Given the following Taylor rule:Target federal funds rate = natural rate of interest + current inflation + 1/2(inflation gap) + 1/2(output gap);Explain what happens to the real interest rate and why it happens, each time inflation increases by 1 percent.
What will be an ideal response?
Each time inflation increases by 1 percent the target interest rate increases by 1.5 percent since the current inflation rate would be 1 percent higher and the additional 0.5 comes from the inflation gap times 1/2. If the target interest rate, which is a nominal rate, is increased by 1.5 percent, while the rate of inflation increased only 1 percent, this tells us that the real interest rate has increased by 0.5 percent since the real interest rate is the nominal interest rate less the rate of inflation.
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