4. The Federal Reserve and other central banks try to stabilize the economy, limiting fluctuations of actual output around potential output, while also keeping inflation low but positive. Under the Taylor rule for monetary policy, the target interest rate rises when there is inflation, or a positive output gap, or both; the target interest rate falls when inflation is low or negative, or when the output gap is negative, or both. Some central banks engage in inflation targeting, which is a forward -

looking policy rule, whereas the Taylor rule is a backward - looking policy rule. In practice, the Fed appears to operate on a loosely defined version of the Taylor rule.

Because monetary policy is subject to fewer implementation lags than fiscal policy, it is the preferred policy tool for stabilizing the economy.