Question at position 10 Using Taylor's rule, when the equilibrium real federal funds rate is 2 percent, there is no output gap, the actual inflation rate is zero, and the target inflation rate is 2 percent, the nominal federal funds rate should be4%1%3%0%2%Single choice
A
4%
B
1%
C
3%
D
0%
E
2%

Question

Question at position 10 Using Taylor's rule, when the equilibrium real federal funds rate is 2 percent, there is no output gap, the actual inflation rate is zero, and the target inflation rate is 2 percent, the nominal federal funds rate should be4%1%3%0%2%Single choice

A

4%

B

1%

C

3%

D

0%

E

2%

BlackTom AI · Accepted Answer

Using the standard Taylor rule: i = r* + π + 0.5(π − π*) + 0.5·(output gap).

1. Relevant knowledge points and concepts
- The Taylor rule gives a policy guideline for the nominal federal funds rate (i) based on: the equilibrium real rate (r*), actual inflation (π), target inflation (π*), and the output gap. 
- The canonical coefficients in the rule are 0.5 on the inflation gap (π − π*) and 0.5 on the output gap.

2. Complete reasoning process step by step
- Start with the formula: i = r* + π + 0.5(π − π*) + 0.5·(output gap).
- Substitute the given values: r* = 2%, π = 0%, π* = 2%, output gap = 0.

3. Calculations with intermediate steps
- Compute r* + π = 2% + 0% = 2%.
- Compute the inflation gap term: 0.5(π − π*) = 0.5(0% − 2%) = 0.5(−2%) = −1%.
- Compute the output gap term: 0.5·(0) = 0%.
- Sum all parts: i = 2% + (−1%) + 0% = 1%.

4. Why the correct answer is correct
- Because inflation is 2 percentage points below target, the Taylor rule prescribes lowering the nominal rate by half of that gap (−1%). Starting from the neutral nominal stance r* + π = 2%, applying the −1% adjustment yields a recommended nominal funds rate of 1%.

5. Why the other multiple-choice options are incorrect
- 4% would imply a large positive policy tightening (would occur if inflation and/or output were above target), which contradicts π < π* here.
- 3% would correspond to a +1% adjustment rather than −1% and does not match the given gaps.
- 0% would require a −2% net adjustment (or different coefficients); the Taylor coefficients here give only −1%.
- 2% would be r* + π with no inflation-gap response; it ignores the fact inflation is below target, so the rule reduces the rate by 1%.

6. Conclusion
- Applying the Taylor rule with the given numbers yields a nominal federal funds rate of 1%, which matches the provided correct answer (1%).