Suppose that the equilibrium real interest rate is 2 percent per year, inflation is 2.5 percent and the output gap is 1 percent. Using the Taylor rule, what is the federal funds rate?
A) 3 percent
B) 3.5 percent
C) 5.25 percent
D) 5.5 percent

Question

Quizplus · Accepted Answer

The Taylor rule formula is: Federal Funds Rate = Equilibrium Real Interest Rate + Current Inflation + 0.5(Output Gap) + 0.5(Inflation Gap). Here, the inflation target is not given, but typically, a 2% target is assumed, making the inflation gap 0.5% (2.5% - 2%). Plugging in the numbers: Federal Funds Rate = 2 + 2.5 + 0.5(1) + 0.5(0.5) = 5.25%.

Suppose That the Equilibrium Real Interest Rate Is 2 Percent