What is the rationale behind the Taylor rule Assuming that t

What is the rationale behind the Taylor rule?

Assuming that the Federal Reserve Bank is following the Taylor rule, how would it react to an increase in inflation above target? Why would your answer be a logical reaction by the Fed

How would the Fed react to an increase in unemployment above the natural rate of unemployment? Why would your answer be a logical reaction by the Fed

Solution

Taylor rule is a monetary policy rule that defines how much the central bank should change the nominal interest rate in response to inflation, output, or other economic condition.

The assumption is that the best that monetary policy can do to support long-term growth of the economy is to maintain price stability. The Fed uses interest rates as the main short-term monetary instrument. An inflation-targeting central bank will raise or lower interest rate based on above-target or below-target inflation respectively. Raising interest rates usually cools the economy to reign in inflation, lowering interest rate usually accelerates the economy thereby boosting inflation.

The natural rate of unemployment is not a physical and unchanging law of nature. It is the unemployment rate that would result from the combination of economic, social, and political factors that exist at a time. Policy makers pursue expansionary monetary and fiscal policies in an attempt to combat high unemployment rate above the natural rate. Attempts to lower unemployment below the natural rate will result in accelerating inflation.

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