Question

An outcome of the covid-19 pandemic has been an increase in unemployment. If the inflation gap was zero when the first unemployment numbers were announced, and assuming no change in r* or the natural rate of unemployment, the response of the federal reserve to the unemployment numbers per the taylor rule would be which of the following?

A. decrease in the fed funds rate

B. increase in the fed funds rate

C. to leave the fed funds rate unchanged

Answer 1

ANSWER : A. decrease in the fed funds rate

REASON :

Taylor’s rule, which is also referred to as the Taylor rule or Taylor principle, is a proposed guideline for how central banks, such as the Federal Reserve, should alter interest rates in response to changes in economic conditions. Taylor’s rule, introduced by economist John Taylor, was established to adjust and set prudent rates for the short-term stabilization of the economy, while still maintaining long-term growth. The rule is based on three factors:

1. Targeted versus actual inflation levels
2. Full employment versus actual employment levels
3. The short-term interest rate appropriately consistent with full employment

In economics, Taylor's rule is essentially a forecasting model used to determine what interest rates will or should be as shifts in the economy occur. Taylor’s rule makes the recommendation that the Federal Reserve should raise interest rates when inflation is high or when employment exceeds full employment levels. Conversely, when inflation and employment levels are low, interest rates should be decreased.

Taylor’s rule was invented and published from 1992 to 1993 by John Taylor, a Stanford economist, who outlined the rule in his precedent-setting 1993 study “Discretion vs. Policy Rules in Practice.” Taylor continued to perfect the rule and made amendments to the formula in 1999.