According to the Taylor rule, if the inﬂation rate is 5 percent and the unemployment rate is 4.3 percent, the
A) inﬂation gap is 2 percent.
B) economic gap is 0.7 percent.
C) unemployment gap is 4.3 percent.
D) inﬂation gap is 3 percent.

Question

Quizplus · Accepted Answer

The Taylor rule states that the nominal interest rate should be equal to the sum of the target inflation rate, the current inflation gap (difference between actual and target inflation), and the output gap (difference between actual and potential GDP), minus a coefficient times the difference between the target inflation rate and the actual inflation rate.

The formula can be written as:

i = r* + π* + 0.5(π - π*) + 0.5(y - y*)

where:
i = nominal interest rate
r* = equilibrium real interest rate
π* = target inflation rate
π = actual inflation rate
y = actual output (GDP)
y* = potential output (potential GDP)

In this case, we are given that:
π = 5%
π* = target inflation rate (unknown)
y = actual output (unknown)
y* = potential output (unknown)
u = 4.3%

Since we are not given any information about y or y*, we can assume that they are equal and cancel each other out in the equation, leaving us with:

i = r* + π* + 0.5(π - π*)

We can rearrange this equation to solve for the inflation gap (π - π*):

π - π* = 2(i - r* - π*)

Plugging in the given values, we get:

π - π* = 2(i - 2 - 5)

π - π* = 2(i - 7)

π - π* = 2(-5.3) = -10.6

Therefore, the inflation gap is -10.6, which means that the actual inflation rate is 10.6 percentage points below the target inflation rate of π*. To get the inflation gap as a percentage of the target inflation rate, we can divide by π* and multiply by 100:

inflation gap = (π - π*)/π* x 100 = (-10.6/π*) x 100

Since we do not know the target inflation rate, we cannot calculate the exact inflation gap as a percentage. However, we know that the inflation gap is negative, which means that there is deflationary pressure in the economy.

The answer choice D is correct because it states that the inflation gap is 3 percent, which is incorrect.

According to the Taylor Rule, If the Inﬂation Rate Is