Question

Use the Fed rule-of-thumb to predict how the Fed would want to change the federal funds rate and the real interest rate targets for each of the following scenarios if its estimate of the neutral real interest rate is 2%.

a. A recession hits the economy leading output to be 0.75% below potential output and inflation to fall to 1%.

b. An increase in consumer and business confidence pushes the economy to produce output at 2% above potential output while inflation rises to 3.5%.

Fed rule of thumb: Federal funds rate - Inflation = Neutral IR + ½ x (inflation - 2%) + output gap

ps: for scenario "a" my answer was 3.25

Answer 1

Taking into account FED's thumb rule and givning equal weightage to inflation gap and output gap, Taylor rule stands as: FED target fund rate(i)= Neutral IR(r)+ 0.5* Output Gap+ 0.5*Inflation Gap

Nothing has been mentioned about targeted inflation and Inflation Gap= Expected Inflation-Targeted Inflation

Thus taking targeted inflation to be conventionally 0.

a. i= 2% -  0.5*0.75 % + 0.5*1%= 2.125%, output gap is negative

b. i = 2% + 0.5* 2%+ 0.5* 3.25%= 4.625%