Suppose that the inflation rate in the United States is 1.5 percent while GDP is 2...

Suppose that the inflation rate in the United States is 1.5 percent while GDP is 2 percent below the potential level. According to the Taylor Rule the Federal Reserve authorities should adjust the stock of base money to drive the target inflation rate to 2 percent. If the current federal funds rate is 2.75 percent, does this mean that the U.S. monetary policy is too tight? Explain (assume the real natural rate of interest is 2 percent and α = β = 0.5). Please use the equation: target rate = neutral rate + 0.5(GDPe - GDPt) + 0.5(le - lt).

Expert Solution

The Taylor Rule can be expressed mathematically by the following formula

Target Rate = Neutral Rate + 0.5 * (GDP_e – GDP_t) + 0.5 * (I_e – I_t)

2.75 + (0.5 * (-2)) + (0.5 * (1.5 - 2))
= 2.75 + (-1) + (0.5 * (-0.5))
= 2.75 -1 - (0.25)
= 1.5

The target rate should be 1.5% which indicates that the current Federal Funds rate of 2.75% is too tight and that is impeding the economic growth. The Federal Fund rate need to be 1.5% according to Taylor Rule to attain the desired economic growth rate.

Rahul Sunny answered 2 years ago

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