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Question: Since monetary policy change made through the federal funds rate occur with a lag, policymakers a...

Show transcribed image text Since monetary policy change made through the federal 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 federal 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 1/2, the equilibrium real federal funds rate is 2%, the inflation rate target is 2%, and the output gap is 0%. (a) If the expected inflation rate is 2%, then what should be federal funds target rate according to the Taylor rule? (b) If the expected inflation rate increases to 3%, what happens to the federal funds rate target? (c) Does this change in the fed funds target rate consistent with the Fed's goal of price stability? Why? (d) If the output gap increases to 2%, what happens to the federal funds rate target? [Assume the expected inflation rate is at its initial level of 2%.] (e) Does this change in the fed funds target rate consistent with the Fed's goal of full employment? Why?

Since monetary policy change made through the federal 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 federal 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 1/2, the equilibrium real federal funds rate is 2%, the inflation rate target is 2%, and the output gap is 0%. (a) If the expected inflation rate is 2%, then what should be federal funds target rate according to the Taylor rule? (b) If the expected inflation rate increases to 3%, what happens to the federal funds rate target? (c) Does this change in the fed funds target rate consistent with the Fed's goal of price stability? Why? (d) If the output gap increases to 2%, what happens to the federal funds rate target? [Assume the expected inflation rate is at its initial level of 2%.] (e) Does this change in the fed funds target rate consistent with the Fed's goal of full employment? Why?