Using the Taylor rule, if inflation is 3 percent, desired inflation is 2 percent, and output is 2 percentage points below potential, the Fed should target a federal funds rate of:
A)6.5.
B)4.5.
C)3.5.
D)3.0.

Question

Quizplus · Accepted Answer

The Taylor rule formula is: Federal Funds Target Rate = Neutral Rate + 1.5(Inflation - Desired Inflation) + 0.5(Output Gap). Assuming a neutral rate of 2% (common assumption), we have: 2 + 1.5(3-2) + 0.5(-2) = 2 + 1.5 - 1 = 2.5. However, none of the options match this calculation directly, suggesting a possible misunderstanding in the application of the formula or a different assumption for the neutral rate. Given the options, the closest to a typical scenario where inflation is above target and output is below potential would be to lower rates to stimulate the economy, but since the question specifies using the Taylor rule and none of the calculations directly match, the best fit with common assumptions (and possibly a different neutral rate or a simplification in the question's context) would be 4.5, which aligns with a scenario of adjusting for higher inflation and an output gap.

Using the Taylor Rule, If Inflation Is 3 Percent, Desired