M&B3 3rd Edition by Dean Croushore

Exercise 4

Suppose that the economy is thought to be 3 percent below potential when potential output grows 3.5 percent per year. Suppose that the Fed is following the Taylor rule (with the equilibrium real federal funds rate assumed to be 2 percent and the weights on the inflation gap and output gap both equal to ½). The inflation rate was 3 percent over the past year. The federal funds rate is currently 4 percent.
a What is the Fed's target for the inflation rate
b Suppose that a year has gone by, output is now just 1 percent below potential, and the inflation rate was 2.5 percent over the year. What federal funds rate should the Fed now set (assuming that the inflation target does not change)