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

Taylor rule says that economy should be at equilibrium, this is a assumption made by him. At equilibrium ,target inflation is achieved and output gap is zero. Federal rate means the rate which is charged by one bank on another for overnight lending to maintain their minimum level of reserves as may be prescribed by the authority.

When fed rate is too high and also inflation is there then it may lead to recession in economy. It is actually used to maintain a balance of money supply. When demand for money is more it goes to high.

If we talk about the state of economy, it can be easily seen with the help of fed rate. Supposed if fed rate reduces in orders to increase the supply of money, firstly it reduces the scarcity but laterly it creates inflation and reduce the purchasing power hence it will reduce the economic stability of state. Taylor assuming about the steady state.

Now calculation of target rate.

Target rate = Inflation rate +Real interest rate +a*(inflation gap) + d*(output gap)

Real interest rate is assumed to be 2%(as per Taylor rule)

a* =0.5 (Taylor assumption)

d* = 0.5 (Taylor assumption)

However assumption may be differ for different professors.

Target rate =2% +2%+0.5(2%)+0.5(2%)

= 6%

And if gap of inflation is -2% and GDP gap =-4%

Then target rate = 2% +2%+ 0.5(-2%)+0.5(-4%)

= 1%

Taylor says nothing when fed rate become negative. Here in the first part we see that target rate 6% and inflation rate is 2% and GDP gap is 2% ,normally we knows that whenever there is inflation fed rate becomes higher in order to stabilize the economy as this is above the stability level.

In the later part we see that inflation target rate is 1% and inflation and GDP gap is negative. We see that the economy is under the economic stability, there is requirement to raise the money for supply. Here the target rate is below the inflation rate also. Their target rate can be interpreted in two ways : one is when target higher than 1% then they can reduce to 1% or below to stabilize the economy. Or if their rate is lower than 1% and then to the economy is having negative inflation gap or GDP gap then to be there is requirement to reduce the target rate in order to stabilize the economy.

Above assumptions are the assumptions as per Taylor and they may be different. Hence fed rate value are effected by the inflation gap and GDP gap. Inflation gap is the difference of actual and expected inflation. Results tell us about the stability of economy. In first part rates are required to be higher and later part rates should be lower that is 0%-1%.