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

Question

Suppose the economy is thought to be 1 percent below its potential output (i.e., the output gap is 1 percent). The potential output is growing at 4% a year. Suppose the Fed is following the Taylor rule, with an inflation rate of 4 percent over the past year. The equilibrium real fed funds rate is 3 percent, the weight on the output gap is 0.75 and the weigh on the inflation gap is 0.25. The inflation target is 1 percent. What should the federal funds rate be?

a. 7 percent

8 percent

9 percent

. 10 percen

a. 7 percent

8 percent

9 percent

. 10 percen

Explanation / Answer

The federal funds rate can be calculated with the use of following formula:

Federal Funds Rate = Current Inflation + Equlibrium Real Feds Fund Rate + 1/2*(Inflation Gap) + 1/2*(Output Gap)

where Inflation Gap = Current Inflation Rate - Target Inflation Rate

__________

Solution:

Here, Current Inflation = 4%, Equlibrium Real Feds Fund Rate = 3%, Inflation Gap = 4% - 1% = 3% and Output Gap = -1

Using these values in the above formula for Federal Funds Rate, we get,

Federal Funds Rate = 4% + 3% + 1/2*(3%) + 1/2*(-1%) = 8% (which is Option B)

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