Question

Assume that the equilibrium real fed funds rate is 2% and that an appropriate target for inflation would also be 2%. The country's potential GDP growth rate is known as 3%. Suppose that the current inflation rate is 3% and actual growth rate is 4%. (a) Then, what would be the central bank's target interest rate implied by Taylor Rule? (b) Suppose current monetary policy interest rate (fed funds rate) is 8%. Evaluate the current monetary policy stance using the Taylor Rule

Answer 1

Taylor’s rule is a tool used by central banks to estimate the target short-term interest rate when expected inflation rate differs from target inflation rate and expected growth rate of GDP differs from long-term growth rate of GDP.

If the growth rate and/or interest rate are higher than the targeted rates the central bank will raise the interest rates which will reduce the money supply in the market in order to keep a check on prices, also with less money supply growth rate will be lowered and vice versa.

According to the Taylor rule

Target Rate = Neutral Rate + 0.5 × (GDP_e − GDP_t) + 0.5 × (I_e − I_t)

Where,

The target rate is the short-term interest rate which the central bank should target;
The neutral rate is the short-term interest rate that prevails when the difference between the actual rate of inflation and target rate of inflation and difference between expected GDP growth rate and long-term growth rate in GDP are both zero;
GDP_e is expected GDP growth rate;
GDP_t is long-term GDP growth rate;
I_e is expected inflation rate; and
I_t is target inflation rate

(A) -

We need to find the target rate

given to us is

GDP_e = 4%
GDP_t = 2%
I_e = 3%
I_t = 2%

Neutral rate = 2%

Target Rate = 2% + 0.5 × (4% − 2%) + 0.5 × (3% − 2%) = 3.5%

So Central bank's short term interest rates should be 3.5%

(B) -

According to taylor rule the interest rates should be set at 3.5% to achieve long term equilibrium, however since fed rate is 8%, A possible explanation of this gap (8%-3.5%) can be the systematic influence of factors other than the dynamics of inflation and output in policy rate setting, specifically of concerns about financial instability and about destabilising capital flow and exchange rate movements.

The stance of the central bank, in this case, is termed as contractionary or hawkish.