Question

Use the following information for a Taylor rule. The equilibrium real federal funds rate is 2%, the inflation target is 2% and the (real) output growth target is 3%.

a) If actual inflation is 3% and actual output growth is 4%, find the federal funds rate recommended by the Taylor rule.

b)   If actual inflation is 1% and actual output growth is 1%, find the federal funds rate recommended by the Taylor rule. How do these numbers compare with the actual values today?

Answer 1

Answer - Taylor rule is a general rule of thumb that is used by the central banks in predicting how the short-term interest rates will be move as a response to the changes in the economy.

It was given by Economist John B. Taylor in 1993, professor of economics at Stanford University

Taylor Formula :-

I=R*+PI+0.5(PI−PI*)+0.5(PI−PI*)

Target Rate = Neutral Rate + 0.5 * (GDPe - GDPt) + 0.5 * (Ie - It)

where:

I=Nominal fed funds rate

R∗=Real federal funds rate (usually 2%)

PI=Rate of inflation

P∗=Target inflation rate

Y=Logarithm of real output

Y∗=Logarithm of potential output​

a) If actual inflation is 3% and actual output growth is 4%, find the federal funds rate recommended by the Taylor rule

Particulars	Value
Neutral Rate	2.00%
Expected GDP Growth Rate (GDPe)	4.00%
Long-Term GDP Growth Rate (GDPt)	3.00%
Expected Inflation Rate (Ie)	2.00%
Target Inflation Rate (It)	3.00%

Target Rate is calculated using the Taylor Rule Formula given below

Target Rate = Neutral Rate + 0.5 * (GDPe - GDPt) + 0.5 * (Ie - It)

2%+0.5*(4%-3%)+0.5*(2%-3%)= 2%

Answer is 2%

b)  If actual inflation is 1% and actual output growth is 1%, find the federal funds rate recommended by the Taylor rule. How do these numbers compare with the actual values today?

Particulars	Value
Neutral Rate	2.00%
Expected GDP Growth Rate (GDPe)	1.00%
Long-Term GDP Growth Rate (GDPt)	3.00%
Expected Inflation Rate (Ie)	2.00%
Target Inflation Rate (It)	1.00%

Target Rate is calculated using the Taylor Rule Formula given below

Target Rate = Neutral Rate + 0.5 * (GDPe - GDPt) + 0.5 * (Ie - It)

= 1.50%

The actual values today -

THIS WEEK	MONTH	YEAR
Fed Funds Rate (Current target rate 0.00-0.25)	0.25	1.75