Question

Suppose the Fed commits itself to the use of the Taylor rule? (shown below) to set the federal funds rate. Federal funds rate equals Long minus run target plus 1.5 left parenthesis Inflation rate minus Inflation target right parenthesis plus 0.5 left parenthesis Output gap right parenthesis Suppose the Fed has set the? long-run target for the federal funds rate at 2.5 percent and its target for inflation at 3 percent. If the economy is currently hitting the? Fed's inflation target and GDP exactly equals the trend? GDP, then the Fed will set the federal funds rate at nothing percent. ?(Enter your response with no rounding?.) Now suppose the economy slows down?, causing the actual inflation rate to decrease to 2 percent and the economy to fall 1.5 percent below trend GDP. In this? case, the Fed will seek to set the federal funds rate at nothing ?percent.(Enter your response with no rounding?.)

Answer 1

Part 1

Long-run target rate = 2.5%

Economy is currently hitting the Fed's inflation target. The inflation target is 3%. So, actual inflation rate is also 3%.

Current GDP exactly equals trend GDP. This means output gap is zero.

Federal funds rate = Long-run target + 1.5(Inflation rate - Inflation target) + 0.5(Output gap)

Federal funds rate = 2.5 + 1.5(3 - 3) + 0.5(0) = 2.5

Thus,

The Fed will set the federal funds rate at 2.5 percent.

PART 2

Long-run target rate = 2.5%

The inflation target is 3%.

Actual inflation rate is 2%

Output gap is 1.5%

Federal funds rate = Long-run target + 1.5(Inflation rate - Inflation target) + 0.5(Output gap)

Federal funds rate = 2.5 + 1.5(2 - 3) + 0.5(1.5) = 2.5 - 1.5 + 0.75 = 1.75

Thus,

The Fed will set the federal funds rate at 1.75 percent.