12 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)?