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 since economy is assumed to be in the ideal situation inflation gap and output gap are 0

So according to the given formula target federal fund rate should be 2% + 2% = 4%