According to the Taylor rule, if the central bank announced a zero percent inflation target but the current inflation rate is 2% and output is 2% below the full-employment level, at what level should the central bank set the nominal interest rate?
A)1%
B)2%
C)3%
D)4%
E)5%

Question

Quizplus · Accepted Answer

According to the Taylor rule, the nominal interest rate should be set based on the target inflation rate, the deviation of actual inflation from the target, and the deviation of output from its full-employment level. If the central bank has announced a zero percent inflation target but the current inflation rate is 2%, then there is an inflation gap of 2% that needs to be closed. Moreover, if output is 2% below the full-employment level, then there is an output gap of 2% that needs to be closed. According to the Taylor rule, the nominal interest rate should be set as:

Nominal interest rate = target federal funds rate + (1.5 x inflation gap) + (0.5 x output gap)

Substituting the given values, we get:

Nominal interest rate = 0 + (1.5 x 2) + (0.5 x 2) = 4%

Therefore, the central bank should set the nominal interest rate at 4%.

According to the Taylor Rule, If the Central Bank Announced