Chapter 1. Chapter 13c (24c)

Step 1

Solved Problems

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

Question

Complete the following equation for the Taylor rule:

Federal funds target rate = 9a375pDfYsw=brSjF5lOKMQ= inflation rate brSjF5lOKMQ= (oG/vuKBFqvk= x inflation gap) brSjF5lOKMQ= (oG/vuKBFqvk= 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).

Step 2

Question

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 BRTW0UzIYJYH10vw9BJw8AMYGxI= and the output gap is BRTW0UzIYJYH10vw9BJw8AMYGxI=.

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%.

Step 3

Question

Suppose that the inflation target is 3% and the output growth target is 4%.

How much should the federal funds target rate be? Q3PdQ4iKdKE=%

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%.

Step 4

Question

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 2m+SZon6QNUVwk/Oj6RZJQoMtN8= and the output gap is jBZBYfR4h9ewdATfu7m66Cn7LYc=.

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%.

Step 5

Question

Suppose that the inflation target is 3% and the output growth target is 4%.

How much should the federal funds rate target be? 0VV1JcqyBrI=%

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%.

Step 6

Question

According to the Taylor rule, then, interest rates are lower when inflation is 2bdsihuL8LcvvgL3 and output growth is 2bdsihuL8LcvvgL3.

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.