Question

Suppose a central bank decides to conduct monetary policy according to a rule for interest rates....

Suppose a central bank decides to conduct monetary policy according to a rule for interest rates.

a) How does it choose the basic setting for the interest rate within the rule?

b) How would it respond to a rise in the output gap (Y −YP)?

c) How would the bank react to an inflation rate higher than its target inflation rate?


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Answer #1

a) The Central bank could choose Taylor's Rule setting the interest rate.

Taylor's Rule says that:

i​​​​= r*+ p+0.5(p–p*)+0.5(Y–Yp)

Where i= Nominal Interest Rate

r*= Real Interest Rate

p= Rate of Inflation

p*= Target Inflation Rate

Y= Output

Yp= Potential Output

b) It would Increase the Nominal Interest Rate as Output Gap Increases as can be seen from the equation above.

c) If Inflation Rate is Higher than its target Inflation Rate then it will increase the Nominal Interest Rate. This again could ne seen from the equation above. In the equation, as p Increases and is Higher than p*, Central bank would Increase the nominal Interest Rate

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