Question

5. A. Explain the Taylor rule (be sure to provide the equation). Tell what the Fed would have to do if inflation or GDP were not at the target rates. B. In some countries, the central bank's only objective is keeping inflation low. What does this imply about the Taylor rule in these countries? C. Suppose a country is at potential or the natural rate of GDP and consumption and investment fall. Illustrate the effects on GDP and interest rates using an IS-LM model. Ignoring inflation, or assuming it is zero, what would the Taylor rule imply the Fed should do? Explain and illustrate on your IS-LM graph. D. Suppose a country is at potential or the natural rate of GDP and people lose faith in the banking system and pull their money out to hold it as cash (increasing the currency deposit ratio). Illustrate the effects on GDP and interest rates with an IS-LM model. Ignoring inflation, or assuming it is zero, what would the Taylor rule imply the Fed should do? Explain and illustrate on your IS-LM graph.

Answer 1

Answer:

5)

Taylor’s rule introduced by economist John Taylor advocates adjustment of interest rate by central bank ex. Fed to control inflation and ensure stabilization of the economy. The rule is based on three factors:

a)

Targeted versus actual inflation rates.

b)

.Full employment versus actual employment levels

c)

Arriving at short-term interest rate consistent with full employment levels

.Taylor’s rule makes the recommendation that the Federal Reserve should raise interest rates when inflation is high or when employment exceeds full employment levels. Conversely, when inflation and employment levels are low, interest rates should be decreased.

I=r* + pi +.5y(pi-pi*) + .5(y-y*) + 2

Where:

• i = nominal fed funds rate
• r* = real federal funds rate (usually 2%)
• pi = actual rate of inflation
• p* = target inflation rate
• Y = real output
• y* =potential output. The Taylor rule specifies that the target federal fund rates should be set to equal the equilibrium real federal funds rate, plus the rate of inflation (for the Fisher effect), plus one-half times the output gap, plus one-half times the inflation gap. The formula is Federal funds rate target = equilibrium real federal funds rate + inflation rate + 1/2(output gap) + 1/2(inflation gap) 2. In some countries, the central bank’s only objective is keeping inflation low it implies that when inflation is at target and output is at potential (the output gap is zero), the real federal funds rate is set at 2 percent. The aim of central bank is to ensure stability in the economy.

c)

When country is at natural level of GDP and Consumption and Investment falls IS curve will shift towards left as demand for goods will fall and demand for money will also fall money supply remains same as a result there is no shift in L M curve.

Interest Rately 22 IS "Cusput (4) As a will rase will result of decrease in spending Is cerve shift towards left as a result interest will fall from OM to on' & Output also fall from on to ON! as a result Note: there Money is no supply remains unaffected change in LN curre.

d)

If people lose faith in the banking system and pull their money out to hold it as cash money supply in the economy will decrease and L M curve will shift towards left but there will be no impact on I S curve. The impact on interest rate and output is illustrated as follows:

Interest Rate (i) When people lose faith In banking system and withdraw money from banking system. Money supply will fall & LM Curre will shift towards left as a result Interest rate will rese as demand for money supply will be INtait. Output will also fall Notes Demand for only supply will remain intent so there will be no change in Is Curve.. Output (4)