Suppose an economy faces the following situation: current federal funds rate = 2%; inflation rate = 3%; inflation rate target = 2%; and current GDP 3% higher than full-employment GDP. According to the Taylor rule, which policy approach should this country be using?

Question

Quizplus · Accepted Answer

The Taylor rule suggests that when the economy is facing an inflation rate above the desired level, the central bank should increase the federal funds rate. In this case, the inflation rate is at 3%, which is higher than the inflation rate target of 2%. Therefore, the economy should be using a tight money policy to reduce aggregate demand and bring inflation back towards the target level. Additionally, the fact that the GDP is currently 3% higher than the full-employment level suggests that the economy may be facing inflationary pressure, further supporting the need for a tight monetary policy.

Suppose an Economy Faces the Following Situation: Current Federal Funds