According to the Taylor rule, if inflation equals 4 percent and there is a recessionary gap equal to 4 percent of potential output, the Fed will set a real interest rate of ________ percent and a nominal interest rate of ________ percent.

Question

Quizplus · Accepted Answer

According to the Taylor rule, r = 0.01 + 0.5 (output gap as a percent of potential GDP)+ 0.5 (inflation rate). Substituting into the equation r = 0.01 + 0.5 (-0.04)+ 0.5 (0.04)= 0.01 - 0.02 + 0.02 = 0.01, or 1 percent. Nominal interest rate = real interest rate + the inflation rate. So the nominal interest rate here is 5 percent (1 percent + 4 percent).

According to the Taylor Rule, If Inflation Equals 4 Percent