Suppose the Fed has set the federal funds rate at 4.5 percent using the Taylor rule. If the inflation rate increases by 1 percentage point and the weight on inflation gap is 0.5, all other variables remain unchanged, the federal funds rate should Question 28Select one: a. decrease to 3.5 percent. b. decrease to 4 percent. c. increase to 5.5 percent. d. increase to 5 percent.
Added by Alberto D.
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The Taylor rule suggests that the federal funds rate should be adjusted based on the inflation gap (the difference between actual inflation and the target inflation rate) and the output gap (the difference between actual output and potential output). The formula Show more…
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Suppose the Fed commits itself to the use of the Taylor rule (shown below) to set the federal funds rate. The federal funds rate equals Long-run target plus 1.5 * (Inflation rate minus Inflation target) plus 0.5 * (Output gap). Suppose the Fed has set the long-run target for the federal funds rate at 2.5 percent and its target for inflation at 3 percent. If the economy is currently hitting the Fed's inflation target and GDP exactly equals the trend GDP, then the Fed will set the federal funds rate at 0 percent. (Enter your response with no rounding.) Now suppose the economy slows down, causing the actual inflation rate to decrease to 2 percent and the economy to fall 1.5 percent below trend GDP. In this case, the Fed will seek to set the federal funds rate at 0 percent. (Enter your response with no rounding.)
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