Question
The Taylor Rule is a guideline for central banks setting
the nominal federal funds rate (iT). If the rule is given by iT=rβ+Ο+0.5(ΟβΟβ)+0.5(YβYβ), where rβ=2%, Οβ=2%, and Y is the output gap (as a percentage), what is the target nominal rate if inflation (Ο) is 4% and the output gap (YβYβ) is 2%?Solution
Solution: The Taylor Rule formula is: iT=rβ+Ο+0.5(ΟβΟβ)+0.5(YβYβ) Given values: rβ (Real equilibrium rate) =2% Οβ (Target inflation rate) =2% Ο (Actual inflation rate) =4% (YβYβ) (Output gap) =2% Substitute the values into the rule: iT=2+4+0.5(4β2)+0.5(2)iT=6+0.5(2)+0.5(2)iT=6+1+1 iT=8%
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