Suppose the equilibrium real interest rate is 2 percent per year, inflation is 2.5 percent and the output gap is 1 percent. Using the Taylor rule, what is the federal funds rate?

Question

Quizplus · Accepted Answer

According to the Taylor rule, the federal funds rate is equal to:

r = r* + π + 0.5 (π - π*) + 0.5 (y - y*)

where

r* = equilibrium real interest rate = 2%
π = inflation rate = 2.5%
π* = target inflation rate (assumed to be 2%)
y = output gap = 1%

Substituting the values in the equation, we get:

r = 2% + 2.5% + 0.5 (2.5% - 2%) + 0.5 (1%) 
r = 5.25%

Therefore, the federal funds rate is 5.25%.

Suppose the Equilibrium Real Interest Rate Is 2 Percent Per