Question

Given the following Taylor rule:

Target federal funds rate = natural rate of interest + current inflation + 1/2(inflation gap) +1/2(output gap);

Explain what happens to the real interest rate and why it happens, each time inflation increases

by 1 percent.

Answer 1

Given the following Taylor rule:

Target federal funds rate = natural rate of interest + current inflation + 1/2(inflation gap) +1/2(output gap);

Taylor rule suggests that the difference between the nominal interest rate and nominal interest rate is inflation. The real interest rate accounts for inflation but the nominal interest rate does not account for it. So when inflation increases the real interest rate decrease. In other words when inflation increases by 1 per cent the real interest rate decrease by 1 per cent. When the inflation is high the real GDP will fall even if it can go to negative in the real term which signals economic contraction. In other words, it tells that when the economy in contraction there is slow economic growth. The slow economic growth causes a decline in real interest rates.