25. Since monetary policy changes made through the overnight interest rate occur with a lag, policymakers are usually more concerned with adjusting policy according to changes in the forecasted or expected inflation rate rather than the current inflation rate. In light of this, suppose that monetary policymakers employ the Taylor rule to set the fed funds rate, where the inflation gap is defined as the difference between expected inflation and the target inflation rate. Assume that the weights on both the inflation and output gaps are ½, the equilibrium real overnight interest rate is 2%, the inflation rate target is 2%, and the output gap is 1%.

a. If the expected inflation rate is 4%, then at what target should the overnight interest rate be set according to the Taylor rule?

b. Suppose half of Bank of Canada economists forecast inflation to be 3%, and half of Bank economists forecast inflation to be 5%. If the Bank of Canada uses the average of these two forecasts as its measure of expected inflation, then at what target should the overnight interest rate be set according to the Taylor rule?

c. Now suppose half of Bank of Canada economists forecast inflation to be 0%, and half forecast inflation to be 8%. If the Bank uses the average of these two forecasts as its measure of expected inflation, then at what target should the overnight interest rate be set according to the Taylor rule?

d. Given your answers to parts (a)–

(c) above, do you think it is a good idea for monetary policymakers to use a strict interpretation of the Taylor rule as a basis for setting policy? Why or why not?