Suppose the inflation rate is 2.5 percent, and the output gap is 1 percent. Using the Taylor rule, the Bank of Canada sets the overnight loans rate equal to
A)3 percent.
B)3.5 percent.
C)5.25 percent.
D)5.5 percent.
E)5.75 percent.

Question

Quizplus · Accepted Answer

According to the Taylor rule, the overnight loans rate is equal to the current inflation rate plus the equilibrium real rate plus (0.5 times the inflation gap) plus (0.5 times the output gap). In this case, the equilibrium real rate is assumed to be 2 percent. Therefore, the overnight loans rate is equal to 2.5 + 2 + (0.5 x 0) + (0.5 x 1) = 5.25 percent.

Suppose the Inflation Rate Is 2