What federal funds rate should the fed now set

Reference no: EM13205517

Suppose that the economy is thought to be 2% above potential (that is, the output gap is 2%) when potential output grows 4% per year. Suppose also that the Fed is following the Taylor rule, with an inflation rate of 2% over the past year. The federal funds rate is currently 3%. The equilibrium real federal funds rate is 3%, and the weights on the output gap and inflation gap are 0.5 each. The inflation target is 1%.

A- Is the federal funds rate currently too high or too low? By how much? Show your work

B- Suppose that a year has gone by, output is now just 1% above potential, and the inflation rate was 1.5% over the year. What federal funds rate should the Fed now set (assuming that the inflation target does not change)?

Reference no: EM13205517

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