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home / study / business / economics / questions and answers / suppose the federal reserve is following the taylor ... Question Suppose the Federal Reserve is following the Taylor rule, which takes both inflation and buiness cycles into account when setting the fedeal funds rate. Also suppose that the inflation rate in the economy is equal to 3 percent and the output gap is 5 percent.. Consider the information provided in the cenario: Taylor Rule: In this case the Federal Reserve will set the funds rate to be equal to: 16 percent, or 6.25 percent, or 5.75 percent, or 4.75 percent.?

Explanation / Answer

The formula for taylor rule is

Where:

i = nominal fed funds rate
r* = real federal funds rate (usually 2%)
pi = rate of inflation
p* = target inflation rate
Y = logarithm of real output
y* = logarithm of potential output

S0,

  i = 2 + 3 + 0.5(3-2) - 0.5*ln5

   i = 5.5 - 0.75

   i = 4.75

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