Based on the Taylor Rule use the following information to calculate the target federal funds rate.

Variable Value
Target inflation rate 2 percent
Current inflation rate 1 percent
Real equilibrium federal funds rate 2 percent
Output gap 10 percent

Answer:

8.0 %

Explanation:

inflation gap = 3 - 2 = 1

=3 + 2 + (.5 x 1) + (.5 x 5)

= 8.0

According to the Taylor Rule, target federal funds rate is 8%.

A targeting rule for monetary policy is the Taylor rule. American economist John B. Taylor suggested the rule in 1992 as a tool for central banks to employ in order to stabilize economic growth by appropriately fixing short-term interest rates. The rule takes into account changes in real income, the level of prices, and the federal funds rate.

In accordance with the rule, the federal funds rate should be higher when inflation is greater than the Fed's inflation objective and lower when inflation is lower.

By following the Taylor principle, inflation-inducing shocks—whether they are supply or demand shocks—raise real interest rates because nominal rates grow more rapidly than inflation, which lowers production and controls inflation while maintaining economic stability.

inflation gap = 3 - 2 = 1

=3 + 2 + (.5 x 1) + (.5 x 5)

= 8.0

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