Suppose that the economy is thought to be 2 percent above potential (that is, th

Question

Suppose that the economy is thought to be 2 percent above potential (that is, the output gap is 2 percent) when potential output grows 4 percent per year. Suppose also that the Fed is following the Taylor rule, with an inflation rate of 2 percent over the past year. The federal funds rate is currently 3 percent. The equilibrium real federal funds rate is 3 percent, and the weights on the output gap and inflation gap are 0.5 each. The inflation target is 1 percent.

a Is the federal funds rate currently too high or too low?
By how much?
Show your work.

b Suppose that a year has gone by, output is now just 1 percent above potential, and the inflation rate was 1.5 percent over the year. What federal funds rate should the Fed now set (assuming that the inflation target does not change)?

Explanation / Answer

Federal funds rate target= equilibrium real federal funds rate + inflation rate + 1/2 (output gap)+ 1/2(inflation gap) = .5x.02+ .5x.01 + .03 + .02 = 6.5% given, The federal funds rate is currently 3% which is low from the target rate. It is low by(6.5-3) 3.5%

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