Question

Suppose that inflation is 2 percent, the Federal funds rate is 4 percent, and real GDP falls 2 percent below potential GDP. According to the Taylor rule, in what direction and by how much should the Fed change the real Federal funds rate?

Answer 1

According to Taylor's Rule -

Federal Funds Target = Inflation +Federal Funds Rate+ 1/2 Inflation Gap + 1/2 GDP Gap.

Here Inflation Gap = (Real Inflation - Target Inflation).

GDP Gap = (Actual Output - Potential Output)

Here in this question -

Federal funds rate = 4%

Inflation = 2%

GDP Gap = -2%

Putting into the Taylor's formula -

Federal Funds Target = 2 + 4 + 1/20 + 1/2 (-2) = 2 + 4 + 0 - 1 = 5%

Here The Real GDP is below the Potential GDP by 2 Percentage points. There should be Reduction in Federal Funds Rate by 1 Percentage point . The Federal funds rate will be 4-1 = 3 % . There will be a fall of 1/2 percentage points to cover up 1 Percent GDP Gap.

answered by: anonymous