Suppose you have the following statistics for the economy. The neutral rate of interest is 2%, the inflation rate is 3.5%, and the output gap is 1.5%. If the Federal Reserve sets the federal funds rate according to the Fed's rule of thumb, then what is the real interest rate?
A)7.75%
B)5%
C)3.5%
D)4.25%

Question

Quizplus · Accepted Answer

According to the Fed's rule of thumb, the real interest rate equals the fed funds rate minus the inflation rate minus the output gap. Therefore, real interest rate = fed funds rate - inflation rate - output gap. 
Plugging in the given values: 
Real interest rate = fed funds rate - inflation rate - output gap
Real interest rate = fed funds rate - 3.5% - 1.5%
Real interest rate = fed funds rate - 5%
Since the neutral rate of interest is 2%, the Fed's rule of thumb implies that the fed funds rate should be 2% + inflation rate + output gap. That is, fed funds rate = neutral rate + inflation rate + output gap. 
Plugging in the given values: 
fed funds rate = neutral rate + inflation rate + output gap
fed funds rate = 2% + 3.5% + 1.5%
fed funds rate = 7%
Therefore, the real interest rate is 7% - 5% = 2%. So the correct option is D) 4.25%.

Suppose You Have the Following Statistics for the Economy