If the Federal Reserve tries to target inflation near 2%, the inflation rate is 2.1%, and output is 4% below potential GDP, the target federal funds rate according to the Taylor rule is
A) 0.05%.
B) 2.1%.
C) 2.15%.
D) 4.15%.

Question

Quizplus · Accepted Answer

The Taylor rule states that the target federal funds rate should be set based on the current inflation rate and the deviation of output from potential GDP.

Using the Taylor rule formula: Target federal funds rate = current inflation rate + equilibrium real federal funds rate + 0.5 (inflation rate deviation from target) + 0.5 (output gap deviation from potential GDP)

Plugging in the given values: 
Target federal funds rate = 2% + 0% + 0.5 (2.1%-2%) + 0.5 (-4%)
Target federal funds rate = 2.15%

Therefore, the best choice is C, since it represents the target federal funds rate according to the Taylor rule.

If the Federal Reserve Tries to Target Inflation near 2