In this equation, it is the prescribed value of the policy interest rate in a given period t; pt — pt* is the deviation of the actual inflation rate p from its target p* in period t; and yt — yt*, the “output gap,” is the deviation of actual real output y from potential output y* in period t. The parameters a and b are positive numbers that describe how strongly the policy rate should respond to deviations of inflation from its target and of output from its potential.
As we would expect, the Taylor rule tells policymakers that interest rates should be higher when inflation is above target, (pt — pt*) > 0, or when output is above its potential, (yt — yt*) > 0. Taylor (1993) estimated the long-run real value of the federal funds rate to be about 2 percent.