Question

(2):

2A. Explain the Taylor rule (be sure to provide the equation and tell what it tells the Fed to do). If the central bank of a country has a policy of inflation targeting, what does this imply about the Taylor rule?

2B. Suppose there is a large contractionary fiscal policy because the government is trying to balance the federal budget when the economy is near full employment. Illustrate this on both an IS-LM graph and an AD-SAS graph, explaining why the curve(s) shift. What would be the effects of this fiscal policy on GDP, interest rates, and inflation? Explain why they change.

2C. Explain what the Taylor rule would tell monetary authorities to do. Illustrate this on both the IS-LM and AD-SAS graphs, explaining why the curve(s) shift. What would be the effects of this monetary policy on GDP, interest rates, and inflation? Explain why they change.

Answer 1

2(A) Taylor's rule is an interest rate forecasting model formulated by John B. Taylor. The rule provides guidelines on how the Federal Reserve should adjust interest rates subject to changes in economic conditions.The formula for the Taylor rule is- i = r + pi + 0.5(pi - pi*) + 0.5(y - y*)

where i = nominal fed funds rate; r = real fed funds rate; pi = inflation rate; pi* = target inflation rate; y = real output (logarithm); y* = potential output (logarithm).

The rule says how Fed should adjust interest rate (the fed funds rate) based on the inflation rate.

If central bank is inflation targetting, then if the inflation rises above target levels then the Fed should raise interest rate and if inflation is below the target level, then Fed should cut interest rates.

(B) A contractionary fiscal policy will impact the IS curve and the AD curve. A policy like a tax hike or reduction in government expense (contractionary fiscal policy) will reduce aggregate spending in the economy and hence both IS curve and AD shift to the left. Hence both these curves will contract and shift to the left. The left movement of IS curve causes interest rates to fall from r0 to r1. A left movement of AD curve causes prices to fall from P0 to P1. The output level falls from Y0 to Y1 levels.

(C) At a time when economy was near full employment level, the contractionary fiscal policy has decreased inflation and output and has increased the output gap. At a time when inflation has fallen below target rates, the central bank (according to Taylor rule) will decrease interest rates by using an expansionary monetary policy. An expansionary monetary policy increases money supply which cause LM curve to shift rightwards. This cause interest rate to fall further below to r2. As interest rates are lowered by central bank, there will higher amount of borrowing in the economy - increasing investment and consumption. Hence aggregate spending will rise. Thus the expansionary monetary policy increases AD and so AD curve shifts rightwards causing price levels to rise back. The level of output will also increase back to near full employment levels. The new price and output level P2 and Y2 will tend to be equal to the previous P0 and Y0 levels of pre contractionary fiscal policy levels.