Assume the Fed uses the following Taylor Rule to set monetary policy: it = 2 + t + 0.5(t 2) + 0.5 100 (yt y ). a. (2 pts.) Extreme events like the Covid pandemic often have lasting effects on the economy. As a result, many analysts have reduced forecasts of long-run growth, leading the Fed to conclude that the long-run real interest rate has fallen to one percent. Assume that the Fed alters its Taylor rule accordingly.

What does the new policy rule look like?

Under the new rule, what would you expect the policy interest rate to average in the long run ?

The Fed expects that the next recession will lower inflation by 2 percentage points and output by 5 percentage points relative to their long-run target levels. Using the new Taylor rule specification, compute the desired policy rate.

Suppose that, in response to rising inflation, Congress makes price stability the top priority of the Central Bank. How would the Fed (qualitatively) alter its Taylor rule to reflect this change?

Over the long-run, how would you expect the volatility of inflation to change under these new priorities ?