Question

Suppose the Federal Reserve's target for inflation is 2%, the current inflation rate is 2%, and the output gap is 4%. What should be the target for the federal funds rate according to the Taylor rule as it is presented in the book?

Answer 1

The target federal funds rate=8%

Step-by-step explanation:

The formula for calculating the target federal funds rate is as follows;

I=R*+PI+0.5(PI-PI*)+0.5(PO-PO*)

where;

I=Target federal funds rate

R=real interest rate

PI=inflation rate

PI*=target inflation rate

PI-PI*=Inflation gap

PO=current output

PO*=target output

PO-PO*=output gap

This can be written as;

Target federal funds rate=real interest rate+inflation rate+0.5×(inflation gap)+0.5×(output gap)

where;

R=2%

PI=2%

PI*=2%

PI-PI*=2-2=0%

PO-PO*=4%

replacing;

Target federal funds rate=2+2+0+4%=8%

The target federal funds rate=8%