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 = Natural rate of interest + Current inflation + 1/2(Inflation gap) + 1/2(Output gap) Instructions: Enter your responses rounded to one decimal place.

If inflation goes up by 1 percentage points, the target (nominal) 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

So according to the Taylor Rule :

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

So, if inflation goes up by 1%,

Then the nominal federal funds rate goes up by 1.5%,

(1 percentage point by the direct impact of inflation and 0.5 by the increase in the inflation gap.)

So according to the Fisher Equation, if inflation goes up b 1%, the nominal rate of interest goes up by 1.5%, the real rate of interest must have increased by 0.5%.