Taylor Rule: Relationship between interest rate and inflation

Question

Q. According to the Taylor Rule, what should the central bank do to stabilize the economy after an increase in oil price?

My points:

• Increase in oil prices (1970's) raises the price of production for producers and hence shifts the AS curve to the left.
• With lower AS and a constant demand the price for goods is raised and inflation increases.
• Taylor rule suggests that in order to counter the effect of inflation and lower it back down to its target (usually 2%), for every percentage point that inflation is above its target, the Fed funds rate should be raised by 0.5%. For example if inflation is at 8% and the target is 2%, 8-2=6% above target so Fed funds rate should be raised by 6x0.5 = 3%.

I think I am correct in saying this but if am not please let me know. What I don't understand is why raising interest rates will actually help?

A higher Fed funds rate means banks will have to charge higher interest to its customers which will surely discourage consumption?

I understand the relationship between inflation and Real interest rate:

i = r + pi (Fisher Equation)

I'm just finding it hard to explain why increased interest will lower inflation in practice, i.e. what this means for consumers.

Does anyone have any pointers?

Thanks again in advance

Answer 1

It's true that in response to an oil shock, the Taylor rule could recommend increasing the interest rate to reduce inflation. In practice it would mean that as interest increases, consumption falls. This could be from less credit financed spending, or because the opportunity cost of holding money has increased, therefore people invest more in illiquid assets (bonds in an IS-LM context) and therefore consume less. As consumption falls, aggregate demand falls, therefore putting pressure off prices causing a reduction in inflation.

Note: an oil shock might also increase the output gap, so its not inherently clear what the taylor rule would say in this situation.

Answer 2

To give some more insight, the oil shock of 1973 was basically a situation of stagflation wherein economy slowed down and inflation rose simultaneously. Such a situation is rare but has happened and is better understood through supply side of macroeconomics. To be precise, the situation of 1973 was a complex one. Since, oil is an essential factor for all industries ,hence, the steep rise in oil prices made the real long term supply curve (which is vertical) shift to left. This phenomenon was not well understood at that time and the policy reacted in the typical Keynesian way i.e. to boost consumption by spending more but in reality they were overshooting the target which led to more inflation as economy was already running hot.