M&B3 3rd Edition by Dean Croushore

Exercise 6

a Write down the equation for the Taylor rule for monetary policy. Explain what each term in the equation means, in one sentence.
b Suppose the Fed is following the Taylor rule. Suppose the growth rate of potential output is 3 percent, the output gap is 26 percent, the weights on the output gap and inflation gap are each ½, the Fed's inflation target is 2 percent, the Fed believes the equilibrium real federal funds rate is 3 percent, and the inflation rate has been 2 percent over the past year. At what level does the Fed set the federal funds rate
c Suppose the Fed thinks that the equilibrium federal funds rate is 3 percent, as in part b above, but in fact the equilibrium real fed funds rate is 4 percent. What do you think will happen to the inflation rate in the long run