13 Suppose that the economy is thought to be 2 percent above potential (that is, the output gap is 2 percent) when potential output grows 4 percent per year. Suppose also that the Fed is following the Taylor rule, with an inflation rate of 2 percent over the past year. The federal funds rate is currently 3 percent. The equilibrium real federal funds rate is 3 percent, and the weights on the output gap and inflation gap are 0.5 each. The inflation target is 1 percent.

a Is the federal funds rate currently too high or too low? By how much? Show your work.

b Suppose that a year has gone by, output is now just 1 percent above potential, and the inflation rate was 1.5 percent over the year. What federal funds rate should the Fed now set (assuming that the inflation target does not change)?

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?