Suppose the equilibrium real overnight interest rate is 5 percent, the target rate of inflation is 3 percent, the current inflation rate is 5 percent, and real GDP is 4 percent above potential real GDP. If the weights for the inflation gap and the output gap are both 1/2, then according to the Taylor rule the overnight interest target rate equals
A)1 percent.
B)5 percent.
C)9 percent.
D)13 percent.
E)17 percent.

Question

Quizplus · Accepted Answer

The Taylor rule formula is: Target Rate = Equilibrium Real Rate + Current Inflation + 0.5*(Inflation Gap) + 0.5*(Output Gap). Here, Inflation Gap = Current Inflation - Target Inflation = 5% - 3% = 2%. Output Gap = Real GDP - Potential GDP = 4%. So, Target Rate = 5% + 5% + 0.5*(2%) + 0.5*(4%) = 13%.

Suppose the Equilibrium Real Overnight Interest Rate Is 5 Percent