Question

Assume the Fed has a target inflation rate of 2% and that the values for how much the nominal target federal funds rate responds to a deviation in inflation from its target,g, and how much the nominal target federal funds rate responds to real GDP , h, are both 0.5 According to the taylor rule if inflation increases by 6% the real interest rate will increase by

Answer 1

Taylor rule is a reduced form approximation of the responsiveness of the nominal interest rate set by the central bank to changes in inflation, output or other economic conditions.

Taylor rule states the below equation :

i = r* + pi + 0.5 (pi - pi*) + 0.5 (y - y*)

i = nominal federal funds rate

r*= real federal funds rate

pi = rate of inflation

pi* = target inflation rate

y = logarithm of real output

y* = logarithm of potential output.

Target Nominal Rate = Inflation rate + Real Interest rate + a*(inflation gap) + b*( output gap)

By substituting the values we get,

= 6% + r* + 0.5 (6% - 2%) + 0.5 (output gap)

= 6% + r* + 0.5 ( 4%) + 0.5 ( output gap)

Target Nominal Rate = 6% + r* + 2% + 0.5 (output gap)

But, Real rate of interest = Nominal rate - Inflation rate

= { 6% + r* + 2%+ 0.5(output gap)} - 6%

= 6% + r* + 2% + 0.5(output gap) - 6%

= r* + 2% + 0.5(output gap)

Hence, the increase in the real rate of interest will be by the amount = r* + 2% + 0.5(output gap).