If the Federal Reserve tries to target inflation near 2%,the inflation rate is 1.5%,and output is 2.3% below potential GDP,the target federal funds rate according to the Taylor rule is 4.4%.

Question

Quizplus · Accepted Answer

The Taylor rule is expressed as follows:

Target federal funds rate = current inflation rate + equilibrium real interest rate + 0.5(inflation rate deviation from target) + 0.5(output gap deviation from potential)

Thus, if the inflation rate is 1.5% and the target is 2%, the inflation rate deviation from the target is -0.5%. If output is 2.3% below potential GDP, the output gap deviation from potential is -2.3%. Using these numbers and assuming an equilibrium real interest rate of 2%, we get:

Target federal funds rate = 1.5 + 2 + 0.5(-0.5) + 0.5(-2.3) = 2.9%

Therefore, the correct answer is B, the target federal funds rate according to the Taylor rule would be 2.9%, not 4.4%.

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