Question

Consider the following data for the U.S. economy:

•  consumer price index (percentage change from year ago) = 1.2

•  real GDP (billion dollars) = 14,542

•  real potential GDP (billion dollars) = 15,372

•  long term real interest rate (percent) = 2.0

•  inflation target (percent) = 2.0

  1. Using the data, find the nominal short term rate that would be predicted by the Taylor Rule. Assume that the weights on inflation and output stabilization are both equal to 0.5.

Answer 1

The taylor rule is given by :

Target Rate = Neutral Rate + 0.5 * (GDPe – GDPt) + 0.5 * (Ie – It)

Neutral Rate (Inflation) = 1.2

GDPe = Expected GDP Growth %

GDPt = Target GDP Growth %

(GDPe – GDPt) This term can be found by finding the %age variance in real and potential GDP.

by (15372-14542)/14542 = 0.057076 = 5.71%

Now putting in the values

Target Rate = Neutral Rate + 0.5 * (GDPe – GDPt) + 0.5 * (Ie – It)

= 1.2 + 0.5(5.71) + 0.5(2-2)

= 1.2 + 2.855 + 0

= 4.055%