Question

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According to the Taylor Rule, if the output gap falls by 2% and the inflation gap...

According to the Taylor Rule, if the output gap falls by 2% and the inflation gap rises by 1%, then the real federal funds rate should be

Select one:

A. lowered by 1.0%.

B. lowered by 0.5%.

C. left unchanged.

D. raised by 1.0%.

Solutions

Expert Solution

According to the Taylor Rule, if the output gap falls by 2% and the inflation gap rises by 1%, then the real federal funds rate should be

correct answer is : B : lowered by 0.5%

The formula is
Federal funds rate target = equilibrium real federal funds rate + inflation rate + 1/2(output gap) + 1/2(inflation gap)

in our case : 1/2(-2) + 1/2(1) = -0.5%

The Taylor rule :

The rules states that the target federal fund rates should be set to equal the equilibrium real federal funds rate, plus the rate of inflation, plus one-half times the output gap, plus one-half times the inflation gap.

The formula is
Federal funds rate target = equilibrium real federal funds rate + inflation rate + 1/2(output gap) + 1/2(inflation gap)


The output gap is the percentage change or deviation of real GDP from potential full-employment real GDP.

where as the inflation gap is the difference between actual inflation and the central bank's target rate of inflation.

ANY DOUBTS, FEEL FREE TO ASK

jeff jeffy answered 2 years ago
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