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Question
Suppose the economy is thought to be 2 percent above potential (i.e., the output gap is 2 percent), when potential output grows 4 percent per year. Suppose the Fed is following the Taylor rule, with an inflation rate of 2 percentover the past year. The federal funds rate is currently 3 percent. The equilibrium real fed funds rate is 3 percent and the weights on the output gap and inflation gap are 5 each. The inflation target is 1 percent.
a. Is the fed funds rate currently too high or too low ? By how much ? Show your work.
Suppose a year has gone by, output is now just 1 percent above potential, and inflation rate
b. was 5 percent over the year. What federal funds rate should the Fed now set (assuming the inflation target does not change)?
Answer
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