Suppose that the economy is thought to be
2 percent above potential (that is, the output
gap is 2 percent) when potential output grows
4 percent per year. Suppose also that the Fed is
following the Taylor rule, with an inflation rate
of 2 percent over the past year. The federal funds
rate is currently 3 percent. The equilibrium real
federal funds rate is 3 percent, and the weights
on the output gap and inflation gap are 0.5 each.
The inflation target is 1 percent.
a Is the federal funds rate currently too high or
Too low? By how much? Show your work.
b Suppose that a year has gone by, output is now
Just 1 percent above potential, and the inflation
Rate was 1.5 percent over the year. What fed-
eral funds rate should the Fed now set (assume-
ing that the inflation target does not change)?
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