Answer the questions below.
a.Suppose (real) output is thought to be 2 percent above potential with an inflation rate of 3 percent over the past year. The weights on the output gap and inflation gap are each 1/2. The inflation target is 1 percent. If you are sure that the equilibrium real federal funds rate is 3 percent, what is the Fed's setting for the federal funds rate, according to the Taylor rule?  b.If you are sure that the equilibrium real federal funds rate is 2 percent, what is the Fed's setting for the federal funds rate, according to the Taylor rule?

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, [(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, i = r* + ? + {w1× [(Y?Y*)/Y*] × 100} + [w2× (???T)] = 3 + 3 + (0.5 × 2) + [0.5 × (3 ? 1)] = 8%.
  
b.i = r* + ? + {w1× [(Y?Y*)/Y*] × 100} + [w2× (???T)] = 2 + 3 + (0.5 × 2) + [0.5 × (3 ? 1)] = 7%.

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