Predicting the Fed Funds Rate. Consider the following monetary policy rule, which is basically a general form of the Taylor Rule expressed in terms of the real interest rate instead of the nominal rate: Rt r = m(t ) + Y t .

(a) Pick some reasonable values for the parameters of this policy rule, and justify your choice of these values.

(b) Obtain data on the inflation rate for the 12-month period ending March 2020 (please use the deflator for Personal Consumption Expenditures excluding Food and Energy for your calculation, series PCEPILFE in the FRED database described below). Assume potential output for 2020Q1 is $19.2 trillion (in chained 2012 dollars) and obtain data on real GDP for that quarter to construct an estimate of Y (use the seasonally adjusted data). A very nice data resource for all of the data you will need is the FRED database of the St. Louis Fed, available here: https://fred.stlouisfed.org/. Use this data and the monetary policy rule to see what fed funds rate the policy rule indicates. How does this compare to the current fed funds rate? Hint: be sure that you are comparing two nominal rates; the rule above corresponds to a real rate.

(c) If they are different, why do you think that is the case?

(d) Suppose the inflation rate fell significantly so that there was substantial deflation. In particular, suppose the inflation rate fell to t = 2% (with the same observed level of short-run output). What level of the fed funds rate would your rule recommend in this case? Is there a problem? What actions would you recommend that the Federal Reserve take?