Question

Suppose Inflation is 2 percent and the inflation gap is 2 percent and real GDP is 2 percent above its potential. What would the Taylor Rule imply for the value of the Federal Funds target? If real GDP falls to 4 percent below its potential and the inflation gap becomes negative 2, what would the Taylor rule suggest happens to the federal funds rate? What does result suggest about the state of the economy?

Answer 1

Question:

Answer:

According to the Taylor Rule, the Federal Reserve should raise interest rates when inflation is above target or when GDP growth is too high and above potential and should lower rates when inflation is below the target level or when GDP growth is too slow and below potential.

Situation 1- Suppose Inflation is 2 percent and the inflation gap is 2 percent and real GDP is 2 percent above its potential. What would the Taylor Rule imply for the value of the Federal Funds target?

Here Fed should increase/raise rate. When Fed raises the rate then it will decrease demand for money that decrease consumption level. Decreasing consumption decrease inflation and or eliminate or control gap.

Situation 2- If real GDP falls to 4 percent below its potential and the inflation gap becomes negative 2, what would the Taylor rule suggest happens to the federal funds rate? What does result suggest about the state of the economy?

Here Fed should decrease/lower rate. When Fed lower the rate then it will increase demand for money that increase consumption level. Increasing consumption increase inflation and or eliminate or control gap. When consumptions increase its increase AD and increasing AD increase output and price level. Increasing output (real GDP) and price level boost the economy growth and eliminate gap.

Normally inflation and GDP growth is directly affected by AD. Decreasing AD decrease output and price level that push the GDP and price level (inflation) below potential level. When Fed decrease interest rate then its increase demand for money and increasing demand for money increase consumption level and increasing consumption level increase AD. Increasing AD or demand increase price (inflation) level and output (real GDP).