Question

state the taylor rule for choosing a target federal funds rate. if current inflation is 5% and target inflation equals 2% and current output is 1% and potential output is 3%, what should the fed do according to the taylor rule? dicuss, including an indication of thr effect on the economy.

Answer 1

Taylor said that a policy formula could be used in 2 ways: as one input to consider when formulating policy and as a means of characterizing the important properties that relate inflation to employment, price levels, and actual output.

Although the actual equation used to determine Taylor's Rule can vary, depending on what central bankers considered more important and on the constant used for the long-term real interest rate, the equation has the following general format:

According to question:

If Fed considers the general long term Interest Rate: 0% to 2.5%

Current Inflation: 5%

Inflation Gap: Current Inlation Rate - Target Inflation Rate: 5-2: 3%

Output Gap: Potential Output - Current Output: 3-1: 2%

Target Interest Rate: 0 + 5 + (1/2 * 3) + (1/2 * 2)

: 7.5%

Target Interest Rate: 2.5 + 5 + (1/2 * 3) + (1/2 * 2)

: 10%

Hence, according to Taylor Rule, if Fed wants to keep Long Term Real Interest Rate in the range of 0% - 2.5%,

it has to keep the Target Interest Rate in the range of 7.5% - 10%.