Suppose government deficits increase such that real interest rates rise by 1.5 percentage points. According to the Taylor rule, if inflation targets remain unchanged, then nominal interest rates should rise by
A) less than 1 percent.
B) between 1 and 1.5 percent.
C) exactly 1.5 percent.
D) between 1.5 and 2 percent.
E) more than 2 percent.

Question

Quizplus · Accepted Answer

The Taylor rule suggests that for each 1 percentage point increase in inflation, the central bank should raise the nominal interest rate by more than 1 percentage point to maintain the real interest rate. However, if the real interest rate rises by 1.5 percentage points due to government deficits and the inflation target remains unchanged, the nominal interest rate should increase by exactly 1.5 percentage points to match the increase in the real interest rate, assuming other factors in the Taylor rule equation remain constant.

Suppose Government Deficits Increase Such That Real Interest Rates Rise