Question

6. The Taylor rule Aa Aa Economist John B. Taylor found empirically that the Federal Reserve (the Fed) tended to follow a general rule for federal funds rate targeting: Federal Funds Target Rate (FFTarget) = 296 + Inflation Rate + [0.5 x (Inflation Gap)] + [0.5 x (Output Gap) Use this relationship to fil in the following table with the target federal funds rate the Fed will set, given the inflation rate, target inflation rate, and output gap percentage. Target Inflation Rate Current Inflation Rate 4% 4% Output GapFederal Funds Target Rate 196 196 4% -4% Under such a rule, the Fed will set real interest rates whenever output is lower than potential GDP.

Answer 1

Given the above formula for Taylor rule and the below description of inflation rate,, inflation gap and output gap, the target federal fund rate can be found as:

Target inflation rate	inflation rate	inflation gap	output gap	Federal fund target rate
1%	4%	-3%	4%	6.5%
1%	4%	-3%	-4%	2.5%

Under such a rule, the Fed will set lower real interest rate whenever output is lower than potential GDP