Assume that the Bank of Canada has a target inflation rate of 2% and that the values for how much the nominal target overnight rate responds to a deviation of inflation from its target,g,and how much the nominal target overnight rate responds to real GDP,h,are both 0.5.According to the Taylor rule,if inflation decreases by 2%,the real interest rate will decrease by
A) 1%.
B) 2%.
C) 3%.
D) 4%.

Question

Quizplus · Accepted Answer

According to the Taylor rule, the change in the nominal interest rate is given by: change in nominal rate = g*(change in inflation) + h*(change in GDP). If inflation decreases by 2%, the nominal rate decreases by 0.5*2% = 1%. Since the real interest rate is the nominal rate minus inflation, the real interest rate decreases by 1%.

Assume That the Bank of Canada Has a Target Inflation