The Taylor Rule and the Norwegian Central Bank

The Taylor rule is the simplest rule describing how the main monetary policy instrument - the policy interest rate - could be set. The rule was formulated by John Taylor in 1993 as a linear dependence of the central bank’s interest rate on the output gap and the deviation of the current inflation from its target level. From then on, the rule gained high popularity with economists who studied monetary policy. This can be explained by a high degree of accuracy with which Taylor described the US monetary policy. However, a number of economists question the Taylor rule’s relevance today and point out some serious flaws in it. The aim of this research is to check whether the Taylor rule in its simple linear form can be viewed as an appropriate description of the monetary policy of Norway’s central bank – Norges Bank, and also whether the rule can be used for forecasting purposes. Not only does this research focus on the original Taylor rule, but it also examines an extended version of the rule designed for small open economies.