Question

ccording to the Taylor rule, under what macroeconomic circumstances should the Federal Reserve raise its federal funds rate target? Please defend your reasoning.

Answer 1

According to Taylor's rule we have

Target for federal funds rate = current rate of inflation + 0.5*(inflation gap) + 0.5*(output gap) + equilibrium federal funds rate in the long run

If the federal reserve is increasing the target for federal funds rate, it must be expecting that

• Current rate of inflation is increased
• Inflation gap is increased implying that current inflation has increased or the target for inflation has reduced
• Output gap has increased implying that actual output is more than its potential output
• There has been an increase in the equilibrium long run federal funds target