Question

The Taylor rule specifies how policymakers should set the federal funds rate target.

Suppose that U.S. real GDP rises 3% above potential GDP, all else constant. According to the Taylor rule, the Fed should (raise lower) the federal funds rate target by (1.75%,1.25%,1.5%,2%)    .

Suppose instead that the U.S. inflation rate rises by 3%, all else constant. According to the Taylor rule, the Fed should (raise,lower) the federal funds rate target by (4.5%,4.75%,5%,4.25%) .

1. The opportunity cost of holding money

Suppose you've just inherited $10,000 from a relative. You're trying to decide whether to put the $10,000 in a non-interest-bearing account so that you can use it whenever you want (that is, hold it as money) or to use it to buy a U.S. Treasury bond.

The opportunity cost of holding the inheritance as money depends on the interest rate on the bond.

For each of the interest rates in the following table, compute the opportunity cost of holding the $10,000 as money.

Interest Rate on Government Bond	Opportunity Cost
(Percent)	(Dollars per year)
5	(10,000.00,200,000.00,.05,5.00,500.00)
3	(10,000.00, .03, 3.00, 333,000.00 , 300.00)

What does the previous analysis suggest about the market for money?

The supply of money is independent of the interest rate.

The quantity of money demanded decreases as the interest rate falls.

The quantity of money demanded increases as the interest rate falls.

Answer 1

If the U.S. real GDP falls 1% below potential GDP, the fed will lower the federal funds rate by half a percentage point. If inflation falls under the fed target by a percent, the fed will lower the federal funds rate by a percentage point and a half.