Question: In using the Taylor Rule as a guideline for monetary policy, what are the pros and cons of using forecasted values of inflation and output rather than observed values of these variables?
Answer:
Taylor rule stipulates that the Fed should increase the nominal interest rates more than the difference between actual and targeted rate if the inflation rate in a period is higher than the targeted rate. However, it uses the forecasted value of output and inflation rather than the actual values. This brings a lack of transparency to the policy recommendations. However, these forecast are not always reliable, and more often than not, it brings ambiguity to the policy implications. Actual data, on the other hand, is more reliable to use. But the forecasted values are forward looking and in that sense it is supposed to predict better results than the actual data, which cannot be available for a period ahead.