Suppose the economy is thought to be 1 percent above potential (i.e., the output

Question

Suppose the economy is thought to be 1 percent above potential (i.e., the output gap is 1 percent), when potential output grows 3 percent per year. Suppose the Fed is following the Taylor rule, with an inflation rate of 3 percent over the past year. The federal funds rate is currently 4 percent. The equilibrium long-run real interest rate is 2 percent and the weights on the the output gap and inflation gap are 0.5 each. The inflation target is 2 percent. a) Is the feds funds rate currently too high or too low? By how much? Show your work. b) Suppose a year has gone by, output is now just 2 percent above potential, and inflation rate was 3.5 percent over the year. What federal funds rate should the Fed now set (assuming the inflation target does not change)?

Explanation / Answer

A) Taylor's rule is a tool used by central banks to estimate the target short-term interest rate when expected inflation rate differs from target inflation rate and expected growth rate of GDP differs from long-term growth rate of GDP. The central banks attempt to achieve the new target rate by using the tools of monetary policy, mainly the open market operations.

Formula

N = I + E + i(T – I) + o(P – O)

N = Suggested Nominal Interest Rate
I = Current Inflation
E = The Equilibrium Real Interest Rate
i = Inflation Coefficient
T = Target Inflation Rate
o = Output Coefficient
P = Potential Output
O = Current Output

N = 3 + 2 + 0.5*( 1 ) + 0.5*( 1 )

N = 5+0.5+0.5

N = 6

Nominal rate or Federal Funds rate appears to be 6%. Current rate appears to be lower by 2%.

B) Now current output is 2% above potential output and inflation has changed to 3.5

N = 3 + 2 + 0.5*( 1.5 ) + 0.5*( 2 )

N = 5 + 0.75 + 1

N = 6.75

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.