Question

Use the following Taylor rule to calculate what would happen to the real interest rate if inflation increased by 1 percentage points.

Target federal funds rate = 2 + Current inflation + 1/2 (Inflation gap) + 1/2(Output gap)

If inflation goes up by 1 percentage points, the target federal funds rate goes up by ___ percentage points ( ___ percentage points due to the direct impact of inflation and another __ percentage points due to an increase in the inflation gap). According to the Fisher equation, if the nominal rate increased by __ percentage points and inflation increased by ___ percentage points, the real interest rate must have increased by ___ percentage points.

Answer 1

When the inflation goes up 1%,

then the Target Fed funds rate must go up 1.5%. The 1% increase will be due to the direct impact current inflation rate and the 0.5% will be due to the inflation gap as per the formula of Taylor rule,

The target federal rate is also the nominal rate, to calculate the impact on real interest rates we use the fisher equation:

Nominal rate = real rate + inflation,

1.5% = real rate + 1%

real rate = 0.5%

so, if the nominal rate increased by 1.5%, the inflation increases by 1%, then the real rate must have gone up by 0.5%.