Question

Use the Taylor Rule (equation) to show what the Federal Reserve would do to the Federal Funds rate if, A) prices fall, and B) unemployment falls.

Answer 1

Taylor rule states that there is a positive relationship between inflation (increased price levels) and nominal interest rates. As a rule, it states that if there is one percentage point increase in inflation, the increase in nominal interest rate would be greater than one percentage point.

1. If prices fall: With a fall in prices or deflation, the Fed should reduce the nominal interest rate

2. Unemployment falls: Unemployment and inflation are usually inversely related (as stated in Phillips curve). When unemployment falls, it is usually related with an increase in price levels. As inflation rises, the Fed would also increase the interest rate.