The Taylor rule was formulated by Professor John B. Taylor, an eminent economist. John Taylor used to advise Ronald Reagan’s government as well as George’s Bush government. John Taylor was one of the most prominent members of the Chicago School. In 1993, John Taylor published a work entitled Discretion versus policy rules in practice (Monetary Policy Rules, Chicago University). In this paper, Professor John Taylor found a certain regularity or, in other words, a rule which would obey the behavior of the Federal Reserve of the United States (Fed) among inflation between 1987 and 1992. From this discovery, Professor Taylor led the behavior of the Fed during those years in a mathematical formula that has taken the name of the “Taylor rule”. This new financial formulae will prevail in history, as it has been one of the biggest revolution in terms of economic intellectual input in the 20th century.
In order to be able to understand the Taylor rule we need to know the difference between the nominal interest rate and the real interest rate. These rates are both related. Nominal Interest rate = Real Interest rate + Inflation. In a simplified form, the nominal interest rate is the total interest that a financial product offers the investor. If a bond pays a 5% a year, the nominal interest rate will be 5%. Then there is the real interest rate, that discounts the inflation from the nominal interest rate. It shows the real gain of the investment. So, if that same bond is bought and there is a 3% inflation rate that year, the real interest rate will be 5 – 3 = 2%.
The real interest rate is the price at which resources between the present and the future are exchanged. In other words, it is the reward a consumer gets in the future by sacrificing a unit of consumption at present. Because when you use your money to invest it, you can’t spend it on anything else for a period of time. Since the days of the great economist Eugen von Böhm-Bawerk, we know that the natural rate of interest (named after Böhm-Bawerk to refer to the real interest rate) not only provides information on consumer preferences; but also informs us about the expectations consumers have about the future and what the subjective value they give to the property they own (Housing, consumption, investment …)
( The formulae is very well explained in Wikipedia, for those who want to take a look at it click on the following link https://en.wikipedia.org/wiki/Taylor_rule )
Central Banks do not use this formulae to make decisions. There are a lot of other factors to take into account. This is just an approximation or a guidance to see if the monetary policy is going in the right direction. It is quite useful for situations where the economy is at the top of its productive capacity. Where there are high inflationary pressures due to a full employment and the difficulty to increase production. So prices go up generating inflation. In this situation the central bank has to be efficient and make the right decisions to avoid a disadjustment of the economy. The economic and monetary policy should contract a bit the economy in order to generate new opportunities for the best actors in the market to fill in the gaps.