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Suppose that in the economy of Moneyland, the rate of inflation is currently 3% but the...

Suppose that in the economy of Moneyland, the rate of inflation is currently 3% but the target is 2%.   The real federal funds rate is 2.5%. The current level of real GDP is $9 trillion, but full employment GDP is $10 trillion. According to the Taylor Rule as presented in Class 16, what is the optimal level for the federal funds rate? Show your work and explain. What happens if real GDP increases to $10 trillion?

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Answer #1

Based on Taylor Rule Principle, we have

Federal Funds rate = Real Federal Funds Rate + + 0.5( - *) + 0.5*(Y - Y*)

= Actual Inflation Rate

* = Target Inflation Rate

Federal Funds Rate = 2.5 + 3 + 0.5(3 - 2) + 0.5(9 - 10)

Federal Funds Rate = 5.5 + 0.5 - 0.5

Federal Funds Rate = = 5.5% : Optimal Level

If Y increase to 10, then

Federal Funds Rate = 2.5 + 3 + 0.5(3 - 2) + 0.5(10 - 10)

Federal Funds Rate = 5.5 + 0.5

Federal Funds Rate = 6%

FFR increases by 0.5%

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