Instructions: Your answers should be precise. Do not give information that is not directly relevant for answering the questions. Show all your work for numerical questions and clearly label the diagrams for graph questions to receive full credit. The assignment will be graded on a scale of 0-4. Clarity and grammatical correctness will carry some weights in the evaluation of this assignment

1. Suppose the economy is 2 percent above potential (i.e., the output gap is 2 percent). The potential output is growing annually at a rate of 3.5 percent. Suppose the Fed is following the Taylor rule. The inflation rate is 4 percent over the past year. The federal funds rate is currently 5 percent. The equilibrium long-run real interest rate is 3 percent and the weights on the output gap and inflation gap are 0.4 and 0.6 respectively. The inflation target is 2 percent.

a) Using the relevant information provided in the description above, calculate the target federal funds rate according to the Taylor Rule. Compare this calculated rate with the current federal funds rate. Determine whether the current federal funds rate is higher or lower than the target rate, and by what margin. Show your calculations. (2 points)

b) Suppose a year has gone by, output is now 1 percent above potential, and inflation rate was 3 percent over the year. What target should the Fed now set for the federal funds rate (assuming the inflation target does not change)? Use the Taylor Rule equation to calculate the new target rate. Show your work. (1 point)

2. Suppose that the interest rate in an economy is 5 percent per month and the cost of going to the ATM is $2 per visit. You spend $3,000 on consumption per month. The price level is $3. What is your monthly total real cost of holding cash as a function of the number of days between trips to the ATM, i.e.,T? (1 point)