Question

Suppose that inflation is 2 percent, the federal funds rate is 4 percent, and real GDP is 3 percent below potential GDP. According to the Taylor rule, in what direction and by how much should the Fed change the real federal funds rate?

Answer 1

The Fed should decrease the real federal funds rate by 0.5%

Step-by-step explanation:

The formula according to Taylor can be expressed as;

N=I+R+0.5(I-I*)+0.5(Y-Y*)

where;

N=nominal fed fund rate

I=inflation rate

R=real federal fund rate

I*=target inflation rate

Y-Y*=output gap

In our case;

N=4%=4/100=0.04

I=2%=2/100=0.02

R=unknown=R

I*=assume 2%=2/100=0.02

Y-Y*=-3%=-3/100=-0.03

replacing;

0.04=0.02+R+0.5(0.02-0.02)+0.5(-0.03)

0.04=0.02+R+0-0.015

0.04=R+0.005

R=0.04-0.005=0.035

Change=R-N

Change=0.04-0.035=0.005

The Fed should decrease the real federal funds rate by 0.5%