Use the following Taylor rule to calculate what would happen to the real interest rate if...

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Use the following Taylor rule to calculate what would happen to the real interest rate if inflation increased by 7 percentage points.

Target federal funds rate = Natural rate of interest + Current inflation + 1/2(Inflation gap) + 1/2(Output gap)

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Answer 1

Answer #1

1) the nominal federal funds rate goes up by 10.5%, 7% due to direct impact of inflation and another 3.5% due to an increase in the inflation gap

2) According to fisher equation, if the nominal rate increased by 10.5% and inflation increased by 7% the real interest rate must have increased by 10.5-7 = 3.5%

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Answer 2

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