Question

write out equation for yield spread

write out equation for the Taylor Rule

Answer 1

Yield spread is the difference between yields on different debt instruments which is calculated by deducting the yield of one instrument from the other. It is mostly expressed in basis points or percentage points.

Yield spread = Higher yield - Lower yield

For example,

If the market rate for a five year bond is 6% and the rate for a one year bond is 4%, the spread is the difference between them which will be 2%.

As mentioned above, yield spread is often expressed in basis points and a 1% difference in yields equals to 100 basis points. Hence, the yield spread for the above example could be stated as 200 basis points.

Taylor rule is based upon three factors:

1. The targeted rate of inflation in relation to the actual inflation rates

2. The real levels of employment, as opposed to full employment.

3. An interest rate consistent with full employment in the short term.

Equation for the Taylor rule:

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

Where;

i = nominal fed 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