Assume that the equilibrium real federal funds rate is 2 and

Assume that the equilibrium real federal funds rate is 2% and the target for inflation is 10%. Suppose that the inflation rate is at 3.5%, leading to an inflation gap of 2.5% equal to 3.5%-1.0%), and real GDP IS 2.0% above its potential, resulting in a positive output gap of 2.0%. The Taylor rule suggests that the federal funds rate should be set at: ? A. 775% OB. 5.75%. OC. 7.50%. OD. 3.75% Click to select your answer Save for Later

Solution

Option A: 7.75%

Below is the Taylor\'s rule equation:

i= r* + pi + 0.5 (pi-pi*) + 0.5 ( y-y*).

i = nominal interest rate/federal interest rate
r* = real interest rate
pi = inflation rate
p* = target inflation rate
y = logarithm of real GDP
y* = logarithm of potential GDP

i = 2+ 3.5+0.5*2.5+0.5*2
i = 7.75%