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a. What does the Taylor Rule imply that monetary policymakers should due to the Federal Funds...

a. What does the Taylor Rule imply that monetary policymakers should due to the Federal Funds Rate under the following scenarios? Please explain your answer using the information in the Taylor Rule. (Hint: you may want to start with the equation for the Taylor Rule.) The Taylor Rule: 1. Unemployment rises due to a recession. 2. An oil price shock causes the inflation rate to rise by 1% and output to fall by 1%. 3. The Fed decreases its target rate of inflation.  b. The Fed has moved away from influencing/controlling the Federal Funds Rate through changes in the monetary base. In January 2019, the Federal Open Market Committee stated that it “intends to continue to implement monetary policy in a regime in which an ample supply of reserves ensures that control over the level of the federal funds rate and other short-term interest rates is exercised primarily through the setting of the Federal Reserve’s administered rates, and in which active management of the supply of reserves is not required.” What are the “Federal Reserve’s administered rates” referred to above? How does the Fed use those rates to maintain the Federal Funds Rate?

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Answer #1

a. Taylor's rule is essentially a forecasting model used to determine what interest rates will or should be as shifts in the economy occur. It is a reduced form approximation of the responsiveness of the nominal interest rate, as set by the central bank, to changes in inflation, output, or other economic conditions. Taylor's rule makes the recommendation that the Federal Reserve should raise interest rates when inflation is high or when employment exceeds full employment levels. The following equation is used by the central banks (with some alterations)

  i = p* + pi + 0.5(pi – pi*) +0.5(y – y*)

Where:

  • i = nominal fed funds rate
  • r* = real federal funds rate (usually 2%)
  • pi = rate of inflation
  • p* = target inflation rate
  • Y = logarithm of real output
  • y* = logarithm of potential output

1.) Unemployment rises due to a recession:-

The Taylor rule says that the target if = + i + 1/2(T – T*) + 1/2(y - y). During a recession, the output falls (y↓) which implies the output gap falls (y - y*)↓ hence the central bank should lower the fed funds rate.

2.) An oil price shock causes the inflation rate to rise by 1% and output to fall by 1%:-

First, let's consider the increase in the inflation rate. Inflation appears twice in the Taylor rule so increasing inflation by 1% means the target fed funds rate should increase by 1.5% (as stated by Taylor principle - an increase in inflation should be offset by an increase in the real interest rate). Second, let's consider output. If output falls by 1%, the target fed funds rate should decrease by .5%. The decrease in the output gap alone would imply the fed funds rate would fall by 0.5 percentage points. Thus, the two factors together imply a net effect of increasing the fed funds rate by one percentage point according to the Taylor rule. The net effect of the oil price shock is that the target fed funds rate should increase by 1%.

3.) The Fed decreases its target rate of inflation:-

If the inflation target is revised downward, this would increase the inflation gap at any given inflation rate. This would result in a higher fed funds rate according to the Taylor rule.

b. “Federal Reserve’s administered rates” referred to above are IOER (the rate of interest paid on excess reserves) and the ON RRP rate (the offered rate at the overnight reverse repurchase agreement facility). This type of regime is often referred to as a “floor system” because the administered rates place a floor under the rates at which banks and other market participants will lend. The Fed uses these rates to maintain the Federal Funds Rate because the Federal Reserve’s administered rates provide strong incentives in money markets.

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