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Question
Suppose the economy is thought to be 2 percent below 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 3 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 thefedfundsratecurrentlytoohighortoolow?By how much?Show your work.
Suppose that all the conditions are the same as described above, except that the output gap is b. +2 percent instead of −2 percent. 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 3 percent above potential, and the inflation rate
c. was 5 percent over the year. What federal funds rate should the Fed now set (assuming the inflation target does not change)? Show your work.
Answer
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