2. Suppose that actual inflation is 2% which is target inflation rate, output gr

Question

2. Suppose that actual inflation is 2% which is target inflation rate, output growth is 2% which is 1% below potential (Y*), actual federal funds rate is 5%. (5 points)

a. Use the Taylor rule to predict the Feds target for the federal funds rate.

b. Explain how the Fed should move the actual federal funds rate to the new target. Should the Fed sell or buy government bonds to meet the new target for the federal funds rate?

c. Is the Fed making monetary policy expansionary or contractionay? Explain

Explanation / Answer

a.

r = p + 0.5y + 0.5 (p – 2) + 2 (federal target for the federal funds rate)

Where r = Federal fund rate

p = Rate of inflation

y = output growth

.05 = 0.02 + 0.5 x 0.02 + 0.5 (0.02 – 2 ) + 2 (federal target for the federal funds rate)

0.05 = 0.02 + 0.01 – 1.98 + 2 (federal target for the federal funds rate)

0.05 – 0.02 – 0.01 + 1.98 = 2 (federal target for the federal funds rate)

2 (federal target for the federal funds rate) = 0.05 – 0.02 – 0.01 + 1.98

2 (federal target for the federal funds rate) = 2.03 – 0.03

2 (federal target for the federal funds rate) = 2

federal target for the federal funds rate = 1

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