Suppose the Bank of Canada's target for inflation is 2 percent.If deviation of output from full-employment output is 1 percent,and the rate of inflation over the previous four quarters is 4 percent,what overnight interest rate the Bank should choose if it follows the Taylor rule?

Question

Quizplus · Accepted Answer

According to the Taylor rule, the overnight interest rate should be set at the target rate plus half the difference between actual and target inflation plus half the difference between actual output and potential output. In this case, the target rate is 2 percent, the actual inflation rate is 4 percent (2 percentage points higher than target), and output is 1 percent below potential.

Thus, the formula for the overnight interest rate comes out to be: 
2 + 0.5(4-2) + 0.5(1) = 7.5 percent.

Therefore, the Bank of Canada should choose an overnight interest rate of 7.5 percent if it follows the Taylor rule.

Suppose the Bank of Canada's Target for Inflation Is 2