If the federal funds rate is set by the Taylor rule and the inflation rate increases...

If the federal funds rate is set by the Taylor rule and the inflation rate increases by 3 percentage points, everything else remaining unchanged, the federal funds rate for a given inflation target should

increase by 4.5 percentage points

decrease by 1.5 percentage points

increase by 3 percentage points

decrease by 3 percentage points

Solutions

Expert Solution

If the federal funds rate is set by the Taylor rule and the inflation rate increases by 3 percentage points, everything else remaining unchanged, the federal funds rate should increase by 4.5 percentage points.

According to Taylor's rule

r = p + .5y + .5(p – 2) + 2

where

r = the federal funds rate

p = the rate of inflation

y = the percent deviation of real GDP from a target

Taylor's rule predict that FOMC will raise the federal funds rate by one-half percentage point above the increase in inflation rate. In other words if inflation increases by 2 percentage point then federal funds rate increases by 3.5 percentage points. Hence the answer is option (a).

Rahul Sunny answered 2 years ago

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