Question

Since monetary policy changes through the fed funds rate occur with a lag, policymakers are usually more concerned with adjusting policy according to changes in the forecasted or expected inflation rate, rather than the current inflation rate. In light of this, suppose that monetary policymakers employ the Taylor rule to set the fed funds rate, where the inflation gap is defined as the difference between expected inflation and the target inflation rate. Assume that the weights on both the inflation and output gaps are, the equilibrium real fed funds rate is 4%, the inflation rate target is 3%, and the output gap is 3%. If the expected inflation rate is 7%, according to the Taylor rule, the fed funds rate should be set at 14.5 %. (Round your response to one decimal place.) Suppose half of Fed economists forecast inflation to be 6%, and half of Fed economists forecast inflation to be 8%. If the Fed uses the average of these two forecasts as its measure of expected inflation, according to the Taylor rule, the fed funds rate should be set at %. (Round your response to one decimal place.)

Answer 1

b) With the expected inflation of 6%

Fed funds rate target = 6+4+0.5*(6-3)+0.5*(3) = 13%

With the expected inflation of 8%

Fed funds rate target = 8+4+0.5*(8-3)+0.5*3 = 16%

Average = 13+16/2 = 14.5% which is the required federal funds rate