Suppose the economy is thought to be 5 percent below potential (i.e., the output gap is −5 percent), when potential output grows 3 percent per year.Suppose the Fed is following the Taylor rule, with an inflation rate of 6 percent over the past year.The equilibrium real fed 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 Fed Funds Rate + Current Inflation + 0.5(Inflation Gap) + 0.5(Output Gap). Here, the Inflation Gap = Current Inflation - Inflation Target = 6% - 1% = 5%. The Output Gap is given as -5%. Plugging these values into the formula gives: Federal Funds Rate = 3% + 6% + 0.5(5%) + 0.5(-5%) = 9%.

Suppose the Economy Is Thought to Be 5 Percent Below