Question

Using the Taylor Rule equation and the following values given:

          π $eDP5EegBbY2kudxo5sAAAAAASUVORK5CYII=$ t = the actual annual expected inflation rate at time t = .05%

           π $eDP5EegBbY2kudxo5sAAAAAASUVORK5CYII=$ * = the target annual inflation rate = 2.0%

          y $kfXgAAAABJRU5ErkJggg==$ t = the actual annual GDP growth rate at time t = .35%

           y* = the potential annual GDP growth rate = 2.5%

                  r * = the neutral real fed funds rate = 2.0%

      β = .5

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Derive the (iFFn*) (nominal fed funds target rate at time t*).

Answer 1

Taylor Rule:

i = r* + pi + 0.5(pi - pi*) + 0.5(y - y*)

where:

i = nominal fed funds target rate

r* = neutral real fed funds rate = 2.0%

pi = actual annual expected rate of inflation = .05%

pi* = target inflation rate = 2.0%

y = actual annual GDP growth rate = .35%

y* = potential annual GDP growth rate = 2.5%

Substitute all the given values in equation for Taylor rule:

i = 2 + .05 + 0.5(.05 - 2) + 0.5(.35 - 2.5)

i = 0

Hence, the nominal fed funds target rate at time t should be 0%