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Question 1 of 6

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You must read each slide, and complete any questions on the slide, in sequence.

Complete the following equation for the Taylor rule:

Federal funds target rate = inflation rate ( x inflation gap) ( x output gap)

The federal funds rate should rise if inflation is high. At the same time, low output relative to trend requires a rate cut. Here, each gap is weighted equally (each gets one-half weight).
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Suppose that the inflation target is 3% and the output growth target is 4%.

If actual inflation is 5% and the output growth rate is 6%, the inflation gap is and the output gap is .

The inflation gap is (actual inflation – inflation target) and the output gap is (actual output growth – output growth target). Here, the inflation gap is 5% - 3% = 2%, and the output gap is 6% - 4% = 2%.
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Suppose that the inflation target is 3% and the output growth target is 4%.

How much should the federal funds target rate be? %

The federal funds target rate = 2 + inflation rate + (½ x inflation gap) + (½ x output gap). Here, the federal funds target rate = 2% + 5% + (½)(2%) + (½)(2%) = 9%.
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Suppose that the inflation target is 3% and the output growth target is 4%.

If actual inflation is 1% and the output growth rate is 2%, the inflation gap is and the output gap is .

The inflation gap is (actual inflation – inflation target) and the output gap is (actual output growth – output growth target). Here, the inflation gap is 1% - 3% = - 2%, and the output gap is 2% - 4% = -2%.
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Suppose that the inflation target is 3% and the output growth target is 4%.

How much should the federal funds rate target be? %

The federal funds target rate = 2 + inflation rate + (½ x inflation gap) + (½ x output gap). Here, the federal funds target rate = 2% + 1% + (½)(-2%) + (½)(-2%) = 1%.
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According to the Taylor rule, then, interest rates are lower when inflation is and output growth is .

The Fed lowers interest rates to combat slow growth and raises them to fight inflation. The numbers in this example match this choice of policy. Positive inflation and output gaps led to high interest rates, while negative gaps resulted in lower interest rates.
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