Question

Imagine you are the chief economist at the Fed and you are trying to convince the Fed governor that she should follow the Taylor rule when setting the fed funds rate. "I don't like this Taylor rule," she says. "I think I can do better than the rule." "However, with the Taylor rule you do not have to think what to do. You just observe the inflation rate and the output growth, and set the interest rate accordingly," you say. "But what would I have to do if output falls way too much and we hit the zero lower bound?" she says. "Look, I suggest the following Taylor rule: i equals pi plus 0.02 plus 0.7 y plus 0.3 left parenthesis pi minus 0.02 right parenthesis, where pi is inflation and y is the deviation of output from the full-employment level," you say in response. "With this rule you will only reach the zero lower bound if:

A-output remains above the full-employment level, while inflation drops below zero.

B-output is at the full-employment level, while inflation recedes from the current 2% to 1%.

C-output falls 5% below the full employment level and inflation accelerates to 10%

D-output falls by 6% below the full-employment level, while inflation remains at the current 2%.

Answer 1

The taylor rule here is given by:

i = inflation + 0..02 + 0.7(output gap) + 0.3(inflation - 0.02)

Sine the output gap has more weight is obvious that interest rates will reach zero when the output gap is highly negative. Thus, putting the value from option (d) in the taylor rule we get,

i = 0.02 + 0.02 + 0.7(-0.06) + 0.3 (0.02 - 0.02)

= 0.04 - 0.042 + 0

= -0.002

Thus, the rates will reach the zero lower bound under this option.

All the other options are wrong as the interest rate does not necessarily fall to zero under them. Thus, the naswer is (d)