Question

In setting monetary policy, which central bank—one that operates according to a Taylor rule or one that operates by inflation targeting—is likely to respond more directly to a financial crisis? Explain.

Short answer

The central bank that uses the Taylor rule will address the financial crisis more directly to target inflation, unemployment, or output rate.

Step-by-step solution

Taylor rule

A Taylor rule for a monetary policy is a rule that sets the interest rates or the federal fund rates specifically following the level of the inflation rate or the unemployment and output rate in the economy.

When a financial crisis occurs, the following happens:

• The inflation rate is too high or too low.
• Output is too higher or too low.
• Unemployment is too high or too low.

During a recession, output and inflation rates are low while the unemployment rate is high. While during a boom, that might turn into an economic bubble, output and prices are too high while unemployment is too low. The Taylor rule allows targeting any of the three to prevent, improve or recover from the financial crisis.

Responding to a financial crisis

Once the economy reaches a state of recession, the unemployment rate increases, and the output rate decreases. Therefore, to revive the economy out of this state so that it does not enter the state of depression, the Fed must target any of these three: inflation, unemployment, and output rate. The condition might get some better.

The central bank that uses only the inflation rate as a target for its monetary policy will not be able to address the issue completely. Thus, to revive the economy from the financial crisis, the central banks that operate on the Taylor rule are likely to operate more directly.