Question

Suppose that inflation is 2 percent, the federal funds rate is 4 percent, and real GDP is 4.5 percent above potential GDP. According to the Taylor rule, in what direction and by how much should the Fed change the real federal funds rate?

Answer 1

The Fed should increase the federal funds rate by 2.25%

Step-by-step explanation:

here, we are trying to know the direction and by how much the Fed change the real federal funds rate.

First, let’s evaluate what the Taylor’s rule says we should do in this particular case.

The Taylor states that for every 1 percent of real GDP above potential output, there should be an increase of the real federal funds rate by 0.5% of a point.

Now for the question, we can see that the GDP is 4.5% above the potential level. This means that according to the Taylor’s rule, the Fed should increase the federal funds rate by 4.50/2 = 2.25%