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Chapter 25: Q.10 (page 676)

How would an unexpected change in the equilibrium real fed funds rate be an argument against using a Taylor rule for monetary policy implementation?

Short Answer

Expert verified

The Taylor rule says when inflation or GDP growth rates are higher than intended, the Federal Reserve should raise interest rates but when the economy is booming, the reasoning is reversed.

Step by step solution

01

Content Introduction

When inflation is high or employment levels are over full employment, the Federal Reserve should raise interest rates, according to Taylor's rule. When inflation and employment are low, however, the Taylor rule suggests that interest rates should be reduced.

02

Content Explanation

The Taylor rule is a formula that can be used to anticipate or direct central banks' interest rate changes in response to economic events. When inflation or GDP growth rates are higher than intended, Taylor's rule suggests that the Federal Reserve should raise interest rates.

According to the hypothesis, decreasing rates lowers borrowing costs, which encourages businesses to take out loans to hire more workers and expand output. When the economy is booming, the reasoning is reversed.

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Most popular questions from this chapter

If the public expects the Fed to pursue a policy that is likely to raise short-term interest rates permanently to 5%, but the Fed does not go through with this policy change, what will happen to long-term interest rates? Explain your answer.

In general, how does credibility (or lack thereof) affect the aggregate supply curve?

Suppose an econometric model based on past data predicts a small decrease in domestic investment when the Federal Reserve increases the federal funds rate. Assume the Federal Reserve is considering an increase in the federal funds rate target to fight inflation and promote a low inflation environment that will encourage investment and economic growth.

a. Discuss the implications of the econometric model鈥檚 predictions if individuals interpret the increase in the federal funds rate target as a sign that the Fed will keep inflation at low levels in the long run.

b. What would be Lucas鈥檚 critique of this model?

In what sense can greater central bank independence make the time-inconsistency problem worse?

Go to the St. Louis Federal Reserve FRED database, and find data on the personal consumption expenditure price index (PCECTPI). Convert the units setting to "Percent Change from Year Ago, " and download the data. Beginning in January 2012, the Fed formally announced a 2% inflation goal over the "longer-term."

a. Calculate the average inflation rate over the last four and the last eight quarters of data available. How does it compare to the2% inflation goal?

b. What, if anything, does your answer to part (a) imply about Federal Reserve credibility?
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