Question

Economists at the Federal Reserve estimate that in the next quarter the output will grow further above the full-employment level and inflation is likely to accelerate from 3% to 4.1%.  Based on the Taylor Rule, what recommendation should the economists give to the Fed governor?
                
Increase the fed funds rate, regardless of the size of the deviation of output from the full employment level
                
Increase the fed funds rate, but only if the deviation of output from the full employment level is larger than 1.1%
                
Increase the fed funds rate, but only if they expect inflation to slow down in the future
                
Lower the fed funds rate

Answer 1

As per Taylor Rule, Fed should raise rates when either one or both of the following occurs

1) The expected inflation is more than the targeted inflation which is true in this case

2) The anticipated rate of GDP growth is more than the long term rate of GDP growth which is also true here.

So the Fed should Increase the fed funds rate, regardless of the size of the deviation of output from the full employment level

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answered by: anonymous