Chapter 19, Problem 23Q

Introduction:

Taylor’s rule is a proposed guideline which describes the interest rate decisions of central banks. It is based on the following three factors:

1) Targeted versus actual inflation levels;

2) Full employment versus actual employment levels;

3) The short-term interest rate appropriately consistent with full employment

According to Taylor’srule the federal funds rate target is calculated using the following formula −

$\begin{array}{l}FederalFundsRateTarget=\\ InflationRate+EquilibriumRealFedFundsRate+\mathrm{½}\left(InflationGap\right)+\mathrm{½}\left(OutputGap\right)\end{array}$

To determine

Requirement 1: Fed funds rate according to Taylor’s rule when unemployment rises due to recession