According to the Taylor rule, if the unemployment rate is 3.3 percent and there is no inﬂation gap, the Fed should
A) raise the Fed's targeted interest rate by 1 percentage point.
B) lower the Fed's targeted interest rate by 1 percentage point.
C) lower the federal funds rate by 3.3 percentage points.
D) do nothing, as the economy will correct itself.

Question

Quizplus · Accepted Answer

The Taylor rule suggests that the Fed should adjust its target interest rate based on the deviation of inflation from its target level and the deviation of output from its potential level. If there is no inflation gap (i.e., inflation is at the Fed's target of 2%) but the unemployment rate is below its natural rate (which is estimated to be around 4%), the Taylor rule recommends raising the Fed's target interest rate. In this case, the unemployment rate is 3.3%, which is lower than the natural rate, so the Fed should raise the target interest rate by 1 percentage point (which is roughly the difference between the actual unemployment rate and the natural rate).

According to the Taylor Rule, If the Unemployment Rate Is