Scenario: Taylor Rule Suppose that the Federal Reserve is following the Taylor rule, which takes both inflation and business cycles into account when setting the federal funds rate. Also suppose that the inflation rate in the economy is 3% and the unemployment gap is -2%. The economy has a(n):
A) inflationary gap since the inflation rate is high.
B) recessionary gap since the economy is not producing potential GDP.
C) inflationary gap since actual real GDP exceeds potential real GDP.
D) recessionary gap since potential real GDP exceeds actual real GDP.

Question

Quizplus · Accepted Answer

C) An inflationary gap occurs when actual real GDP exceeds potential real GDP, which is often accompanied by higher inflation rates. A negative unemployment gap (-2%) suggests that unemployment is lower than the natural rate, indicating that the economy is overheating and producing above its potential, leading to inflationary pressures.

Scenario: Taylor Rule Suppose That the Federal Reserve Is Following