Answer the questions below.
a.Write down the equation for the Taylor rule for monetary policy. Explain what each term in the equation means, in one sentence. b.Suppose the Fed is following the Taylor rule. Suppose the growth rate of potential output is 4 percent, the output gap is 3 percent, the weights on the output gap and inflation gap are each 1/2, the Fed's inflation target is 2 percent, the Fed believes the equilibrium real federal funds rate is 2 percent, and inflation has been 3 percent over the past year. At what rate does the Fed set the federal funds rate? c.Suppose the Fed thinks that the equilibrium federal funds rate is 2 percent, as in part b above, but in fact the equilibrium real fed funds rate is 3 percent. What do you think will happen to the inflation rate in the long run?
What will be an ideal response?
| a. | 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,  is the output gap, w2 is the weight on the inflation gap, and  is the inflation gap. |
| b. | i = r* + ? + {w1× [(Y?Y*)/Y*] × 100} + [w2× (???T)] = 2 + 3 + (0.5 × 3) + [0.5 × (3 ? 2)] = 7%. |
| c. | The Fed would be continuously setting the nominal interest rate too low by 1 percent because of its error in the equilibrium real federal funds rate. With the nominal interest rate too low, inflation would become higher than the Fed's target. |
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