If the Federal Reserve tries to target inflation near 2%,the inflation rate is 3%,and output is 3% below potential GDP,the target federal funds rate according to the Taylor rule is:
A) 3%.
B) 4%.
C) 5%.
D) 6%.

Question

Quizplus · Accepted Answer

The Taylor rule states that the federal funds rate should be set based on the inflation rate and the output gap. The formula for the rule is:

Fed funds rate = 2% + current inflation rate + (0.5 x inflation gap) + (0.5 x output gap)

In this scenario, the inflation gap is 1% (3% inflation - 2% target inflation) and the output gap is -3% (3% below potential GDP). Plugging in these numbers, we get:

Fed funds rate = 2% + 3% + (0.5 x 1%) + (0.5 x -3%)
Fed funds rate = 2% + 3% + 0.5% - 1.5%
Fed funds rate = 4%

Therefore, the target federal funds rate according to the Taylor rule is 4%.

If the Federal Reserve Tries to Target Inflation near 2%,the