Suppose the economy is thought to be 1 percent below its potential output (i.e., the output gap is −1 percent).The potential output is growing at 4% a year.Suppose the Fed is following the Taylor rule, with an inflation rate of 4 percent over the past year.The equilibrium real fed funds rate is 3 percent, the weight on the output gap is 0.75 and the weigh on the inflation gap is 0.25.The inflation target is 1 percent.What should the federal funds rate be?

Question

Quizplus · Accepted Answer

The correct answer is A. The Taylor rule is:FFR = r + \pi + 0.5 * ( \pi - \pi^* ) + 0.5 * ( Y - Y^* )where:FFR is the federal funds rater is the equilibrium real fed funds rate\pi is the inflation rate\pi^* is the inflation targetY is the actual outputY^* is the potential outputPlugging in the given values, we get:FFR = 3 + 4 + 0.5 * ( 4 - 1 ) + 0.5 * ( -1 ) = 7Therefore, the federal funds rate should be 7 percent.

Suppose the Economy Is Thought to Be 1 Percent Below