Question

As the text explains, “in practical terms central banks set their short-term [key policy] interest rate instrument based on their inflation target and their assessment of current and future economic conditions. This approach is described by [the Taylor] policy rule for setting the [key policy] interest rate.” The Taylor Rule is given as follows:

i = i₀ + ∝ (π- π*) + β [(Y- Yp)/Yp]

i. how this “Taylor Rule” responds to where, (1) the current rate of inflation, π is above the inflation-control target; and where (2) the economic conditions suggest an economy moving into a significant Inflationary gap?

Answer 1

As per Taylor rule

Interest rate = Real Interest rate + a* (Actual Inflation - Target Inflation) + (1-a) *(Output gap)

As we can see from the question,

Actual Inflation is greater than Target Inflation and economy is having a positive output gap and it is operating into significant inflationary gap.

This willl lead to Increase in Interest rates because both output gap and inflation differential is increasing, therefore to curb rising prices, central bank will increase interest rates as derived from Taylor rule.

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