Taylor rule & inflation

Taylor rule & inflation
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First Published: Sat, Jun 21 2008. 12 18 AM IST
Updated: Sat, Jun 21 2008. 12 18 AM IST
The only worthwhile question right now is not whether interest rates should be raised, but when and by how much?
The steep climb in the rate of inflation shows quite clearly that this is not some temporary problem that will go away soon. Most bankers, economists and bond market traders are betting that the Reserve Bank of India will have to increase the cost of money.
By how much? It is never easy to guess. But there are a few quick rules that could serve as a guide. The most famous is the Taylor rule, named after economist John B. Taylor. It says the policy rate should be a function of two factors: one, the gap between actual and target inflation; two, the gap between actual output and potential output.
A more rough rule is that long-term interest rates should equal the GDP growth rate. Both suggest that policy interest rates should be far higher. We know that RBI is not bound by these rules—and nor do we say that it should.
The more limited point is that interest rates are way too low. RBI should start moving them up soon.
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First Published: Sat, Jun 21 2008. 12 18 AM IST