If output were at potential and inflation were 4 percent (2 percent above the central bank's target), the appropriate setting of the federal funds rate under a Taylor would be

Question

Quizplus · Accepted Answer

The Taylor Rule formula suggests that the federal funds rate should be adjusted based on the current inflation rate and the deviation of actual economic output from potential output. Given that inflation is 2 percent above the target, and assuming the central bank's target inflation rate is 2 percent (as implied), the Taylor Rule would suggest setting the federal funds rate at 1% (the assumed neutral rate) + 2% (the target inflation rate) + 0.5*2% (the deviation from target inflation) + 0.5*0 (since output is at potential, there's no output gap), totaling 4% + 0.5*2% = 5% + 2% (for the inflation rate being 2 percent above target) = 7%.

If Output Were at Potential and Inflation Were 4 Percent