Question

In: Finance

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


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