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4 February, 05:36

Suppose the Federal Reserve's target for inflation is 2%, the current inflation rate is 2%, and the output gap is 4%. What should be the target for the federal funds rate according to the Taylor rule as it is presented in the book?

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  1. 4 February, 05:48
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    The target federal funds rate=8%

    Explanation:

    The formula for calculating the target federal funds rate is as follows;

    I=R*+PI+0.5 (PI-PI*) + 0.5 (PO-PO*)

    where;

    I=Target federal funds rate

    R=real interest rate

    PI=inflation rate

    PI*=target inflation rate

    PI-PI*=Inflation gap

    PO=current output

    PO*=target output

    PO-PO*=output gap

    This can be written as;

    Target federal funds rate=real interest rate+inflation rate+0.5 * (inflation gap) + 0.5 * (output gap)

    where;

    R=2%

    PI=2%

    PI*=2%

    PI-PI*=2-2=0%

    PO-PO*=4%

    replacing;

    Target federal funds rate=2+2+0+4%=8%

    The target federal funds rate=8%
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