Some economists have proposed that central banks should use the following rule for choosing its target interest rate (r): r ¼ 2% þ p þ 1/2 (y – y*)/y* þ 1/2

(p – p*), where p is the average of the inflation rate over the past year, y is real GDP as recently measured, y* is an estimate of the natural rate of output and p* is the central bank’s target rate of inflation.

a. Explain the logic that might lie behind this rule for setting interest rates. Would you support the use of this rule?

b. Some economists advocate such a rule for monetary policy but believe p and y should be the forecasts of future values of inflation and output. What are the advantages of using forecasts instead of actual values? What are the disadvantages?