Suppose the economy is thought to be 1 percent below potential (i.e., the output gap is −1 percent), when potential output grows 4 percent per year.Suppose the Fed is following the Taylor rule, with an inflation rate of 4 percent over the past year.The equilibrium real federal funds rate is 3 percent and the weights on the output gap and inflation gap are 0.5 each.The inflation target is 1 percent.What should the federal funds rate be?

Question

Quizplus · Accepted Answer

The Taylor rule formula is: Federal Funds Rate = Equilibrium Real Rate + Inflation + 0.5*(Inflation Gap) + 0.5*(Output Gap). Here, Inflation Gap = 4% - 1% = 3%, Output Gap = -1%. So, Federal Funds Rate = 3% + 4% + 0.5*(3%) + 0.5*(-1%) = 8%.

Suppose the Economy Is Thought to Be 1 Percent Below