Suppose that the economy is thought to be 2% above potential ( that is, output g

Question

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


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

Explanation / Answer

A. 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% B. Federal funds rate target= .03+.02+(.5x.01)+(.5x.005) =5.75%

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