Question

According to the Taylor rule, under what macroeconomic circumstances should the Federal Reserve raise its federal funds rate target? Please defend your reasoning.

Answer 1

According to the Taylor rule, Federal Reserve should increase the federal funds rate target when inflation is above level of target or if the growth of gross domestic product (GDP) is above potential or very high. It also states that Fed must reduce the rates when inflation is below the level of target or if the growth of GDP growth is below potential or too slow. Taylor rule was created for the adjustment and setting on the prudent rates for the stabilization of the economy in short-term however also maintaining the growth in long-term. However the rule was criticized on the grounds that it cannot take into consideration the sudden turns or jolts in the economy, such as a housing or stock market crash. Moreover the main concern with the Taylor rule is the difficulty in measurement of the GDP/ unemployment and inflation, metrics which are unobservable actually in real time. In metrics even he minor variations can throw the Taylor rule out of whack, causing the monetary policy to worsen the economy rather than improving it