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 = 10 + < (TT- T*) + B [(Y- Yp)/Yp] i. Explain carefully how this "Taylor Rule" responds to where, (1) the current rate of inflation, Tis above the inflation-control target; and where (2) the economic conditions suggest an economy moving into a significant Inflationary gap? [NOTE: there is no specific values associated with part (i), just direction of change resulting from inflation and level of economic activity.] (4 Marks)

Answer 1

Taylor rules recommend a setting for the level of the federal funds rate based on the state of the economy. For instance, they may recom- mend raising the federal funds rate when infla- tion is above target or lowering the federal funds rate when a recession appears to be more of a threat. With respect to the choice of the weight on the output gap, the research on Taylor rules does not provide much basis for choosing between 0.5 and 1.0. However, the choice of 1.0 seems best to describe the FOMC's efforts to support job growth while also keeping inflation close to target in the medium term.

The Taylor Rule suggests that the Federal Reserve should raise rates when inflation is above target or when gross domestic product (GDP) growth is too high and above potential. It also suggests that the Fed should lower rates when inflation is below the target level or when GDP growth is too slow and below potential.   The inflationary gap exists when the demand for goods and services exceeds production due to factors such as higher levels of overall employment, increased trade activities or increased government expenditure. This can lead to the real GDP exceeding the potential GDP, resulting in an inflationary gap. The self-correction mechanism acts to close an inflationary gap with higher wages and a decrease in the short-run aggregate supply curve. ... The key to this process is that changes in wages and other resource prices cause the short-run aggregate supply curve to shift.