If the Federal Reserve tries to target inflation near 2%, the inflation rate is 3%, and output is 3% below potential GDP, then the target federal funds rate according to the Taylor rule is
A) 3%.
B) 4%.
C) 5%.
D) 6%.

Question

Quizplus · Accepted Answer

According to the Taylor rule, the target federal funds rate equals the sum of the equilibrium real federal funds rate (which is generally estimated to be around 2%) plus one-half of the inflation gap (which is the difference between the current inflation rate and the target inflation rate of 2%) plus one-half of the output gap (which is the difference between current output and potential GDP). Using this formula, we get:

Target federal funds rate = 2% + 0.5(3% - 2%) + 0.5(3% below potential GDP) = 4%

Therefore, B is the correct answer.

If the Federal Reserve Tries to Target Inflation near 2