Question

How would a central bank following the Taylor Rule with focus on inflation targeting react to the increase in expected inflation?

Answer 1

Answer - As per the Taylor rule , when the expected inflation rate is about to rise in the economy , the government should raise the interest rates in the economy. This will be done by reducing the supply of money in economy. The selling of the bonds in the open market is one such tool which will lead to the rise in interest rates in the economy bringing the downfall in the money supply thus stopping the pace of inflation in economy. In case of recession , the interest rates need to fall.