Question

Using the Taylor Rule as described in Chapter 9, explain what happens to the economy when the Fed increases the nominal interest rate by less than the increase in inflation.

Answer 1

Taylor rule defines the procedure that can be adopted to set interest rate by the central bank of country. Rate of interest must be larger than inflation rate. If inflation rate is 1 %, then Federal Reserve must set interest rate larger than 1 %. it will help to deal with problem of inflation.

If central bank does not set interest rate above the inflation rate, it will not be able to achieve the stabilizing objective in short run. Thus, eventually, there will be rise in the instability in financial environment.