nominal federal funds rate, y is real GDP, y* is an estimate of the natural rate of output, π is the inflation rate, and π* is the inflation target. Other things the same, if the economy starts at y* and π* and then y rises and exceeds y* by 1% and π rises 2% points above π*, the rule would require the Fed to raise the federal funds rate by

Question

Quizplus · Accepted Answer

According to the Taylor rule, the appropriate change in the federal funds rate is given by:

Δff = r* + π* + 0.5(π - π*) + 0.5(y - y*)

Here, r* is the equilibrium real interest rate, which we assume to be 2%. Also, we are told that y initially equals y* and π initially equals π*. Therefore, the initial federal funds rate consistent with the Taylor rule is:

ff = 2 + 2 + 0.5(0 - 2) + 0.5(0 - 0) = 3

Now, when y exceeds y* by 1% and π exceeds π* by 2% points, the new federal funds rate consistent with the Taylor rule is:

ff' = 2 + 2 + 0.5(2 - 2) + 0.5(1 - 0) = 3.5

Therefore, the required change in the federal funds rate is:

Δff = ff' - ff = 3.5 - 3 = 0.5, or 50 basis points, or 0.5 percentage points.

Therefore, the answer is C) 3.5 percentage points.

Nominal Federal Funds Rate, Y Is Real GDP, Y* Is