Question

Recall the Taylor Rule for interest rate targeting. ? = ? ∗ + ? + ?(? − ? ∗ ) + ?? ? Consider an economy where the equilibrium real interest rate is ? ∗ = 0.02 and the central bank’s target inflation rate is ? ∗ = 0.02. The central bank equally weights inflation and output deviations, i.e. ? = ? = 0.5

a. Suppose that inflation is currently 1.3%. Also, while the economy’s potential GDP is $12 trillion, actual GDP is only $11.7 trillion. What interest rate would the Fed set?

b. The following year, the price level is totally flat (zero inflation), but there is an output gap of −8% (i.e. output 8% lower than potential). What interest rate would the Fed ideally set?

c. What is the practical problem with using monetary policy in the economy in (b)? What name do we give to this phenomenon?

Answer 1