Suppose the federal funds rate is 4.4 percent and you know that the Fed is following the Taylor rule. You don't know the Fed's inflation target, but the equilibrium real interest rate is 4 percent, the inflation rate is 3 percent, the weight on the GDP gap is 0.4, the weight on the inflation gap is 0.6 and nominal GDP is 2 percent points below its target. Calculate the Fed's inflation target from this information.
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What will be an ideal response?
The Taylor rule is given by the equation i = r* + ? + {w1× [(Y?Y*)/Y*] × 100} + [w2× (???T)], where all variables are measured in percentage points, i is the nominal federal funds rate, r* is the equilibrium value of the real federal funds rate, ? is the inflation rate over the last four quarters, w1 is the weight on the output gap, [(Y?Y*)/Y*] × 100 is the output gap, w2 is the weight on the inflation gap, and ???T is the inflation gap. In this case, using the formula, ?T = 0.?
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