Question

Suppose the unemployment rate rises above the natural rate of unemployment. According to the Taylor rule, should the fed funds rate target be set above or below the neutral fed funds rate?

Answer 1

The Taylor Rule is based on three primary factors -

1. Actual employment as compared to natural rate of employment

2. Short-term interest rate being consistent with full employment

3. Targeted inflation as compared to actual inflation

In the given scenario, the unemployment rate rises above the natural rate of unemployment. This implies that the economy is in a slowdown or recession.

Therefore, according to Taylor Rule, the fed funds rate target should be set below the neutral fed fund rate.

It is important to remember that at neutral fed fund rate, the actual employment is in-sync with natural employment. When unemployment rises, the actual employment goes below the natural employment and hence expansionary monetary policy is recommended as per Taylor Rule. This includes setting rates below the neutral fed fund rate.