Question

1. Use the Taylor rule to:
   1. Calculate the target for the federal funds rate for October 2012, using the following information: equilibrium real federal funds rate of 2%, target inflation rate of 2%, current inflation rate of 1.2%, and a (negative) output gap of 5.9%. In your calculations, the inflation gap is negative if the current inflation rate is below the target inflation rate.
   2. How does the targeted federal funds rate calculated using the Taylor rule compare to the actual federal funds rate of 0% to 0.25% at the time? Briefly explain the implication(s) of this.

Answer 1

Solution:

(a)  target for the federal funds rate for October 2012 is:

Taylor rule of interest rate calculation developed by John Taylor , in order to find the Federal fund rate adjusted with inflation rate with formula below as:

Federal fund rate = equilibrium real fed rate + inflation rate + 1/2 * inflation gap + 1/2 * Output gap

Federal funds rate = 2% + 2% + 1/2*(1.2% – 2%)+ 1/2*(-5.9%) = 0.65%.

(b) compare targeted federal funds rate calculated using the Taylor rule to the actual federal funds rate of 0% to 0.25% at the time :

The calculated Taylor rule federal funds rate target exceeds the actual target range of

0.00 to 0.25%.