You are sitting at your desk in your new job as the Chair of the Federal Reserve Bank of the United States. The interest rate where potential GDP meets real GDP is 2%, the inflation rate is 1%, and the output gap is -1%. What is the appropriate new nominal federal funds rate that you should set for the economy?

Question

Quizplus · Accepted Answer

To close the output gap of -1%, the Federal Reserve should stimulate the economy by lowering the nominal federal funds rate. To avoid overheating, the appropriate rate should be higher than the current inflation rate of 1%. Hence, the appropriate new nominal federal funds rate would be 1% (inflation rate) + 1.5% (half the output gap) = 2.5%. Therefore, choice (D) is the correct option.

You Are Sitting at Your Desk in Your New Job