Your economics instructor has decided that you are the best person to assist the

Question

Your economics instructor has decided that you are the best person to assist the Federal Reserve with a problem they have related to United States monetary policy. The Federal Reserve has collected some data for the years 2005 and 2010 in relation to the actual federal funds rate, the inflation rate, and the output gap. They have also estimated the inflation rate and the output gap for 2015 Using the information in the table, please answer the following questions according to the Taylor Rule for Monetary Policy 1. What is the Taylor Rule for Monetary Policy calculation for the year 2005? Year Actual Federal Inflation Output Rate (%) Taylor | Gap (96) | Rule for Monetary Policy (%) To be determined To be determined To be determined Funds Rate (%) 1.95 Number 2. Calculate the value for the Taylor Rule for Monetary Policy for the year 2010. Compare this value with the Actual Federal Funds Rate (AFFR). The Taylor Value is: 2005 2010 2015 3.35 2.52 3.97 1.52 1.34 2.85 3.21 To be determined O lower than the AFFR O higher than the AFFR O the same as the AFFR 3. If the Federal Reserve sets the Actual Federal Funds Rate according to the Taylor Rule for set the Actual Federal Funds Rate to in 2015? Monetary Policy, what should the Federal Reserve Number

Explanation / Answer

Taylor rule says that

r = p + .5y + .5(p – 2) + 2

where

r = FFR

p = inflation rate

y = output gap

hence

1)

Year 2005: Taylor FFR=3.35%+ 0.5*1.52%+0.5*(3.35%-2%) + 2%=6.785%

2)

Year 2010: Taylor FFR=2.52%+ 0.5*1.34%+0.5*(2.52%-2%) + 2%=5.45%

But actual FFR was 3.21%

So, Taylor value is higher than actual FFR

3)

Year 2015: Taylor FFR=3.97%+ 0.5*2.85%+0.5*(3.97%-2%) + 2%=8.38%

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