Question 3 Taylor Rule Consider the following Taylor rule Ta

Question 3. Taylor Rule Consider the following Taylor rule: Target federal funds rate-2% + Current inflation + 1/2 (inflation gap) + 1 /2 (Output gap) 1. If the economy is in its ideal situation, where output level is at potential GDP, and inflation 2. Calculate what would happen to the real interest rate if inflation increased by 3 percentage 3. Give your intuition about the monetary policy (i.e., to target higher interest rate) used by the rate is at the Fed\'s long-run target, 2%. What is the target federal funds rate? points. Fed in face of an inflation. (Hint: You may use the AD-AS model to formulate your answer.)

Solution

(1) In this case,

Inflation gap = 0 and Output gap = 0 when output level equals potential GDP.

Target federal funds rate = 2% + 2% = 4%

(2) When current inflation rate = 3%,

Inflation gap = 3% - 2% = 1%

Target federal funds rate = 2% + 3% + (1/2) x (1%) = 5% + 0.5% = 5.5%

(3) When inflation rate exceeds the target inflation rate, it signifies that aggregate demand has increased, causing an inflationary gap. The suitable monetary policy would be a contractionary monetary policy by reducing money supply via an increase in interest rate, which will dampen investment and consumption demand, lowering aggregate demand and reducing inflation rate.