Suppose Bangladesh Bank (BB) decided to follow the Taylor rule to conduct monetary

policy. BB's target interest rate is the lending rate. The economists in BB understands that

there will be some time lag for their policy to be effective and therefore they use a

forecasted or expected inflation rate (instead of current inflation rate) in their policy rule.

BB is equally concerned about output and inflation. According to BB's estimate the

equilibrium real lending rate is 5 percent. BB's inflation target is 3 percent and the

deviation of actual output from the potential output (as measured by the HP filter) is 1

percent.

a. If the expected inflation rate is 6%, then at what target should the lending rate be set

according to the Taylor rule? (2 Mark)

b. Suppose half of BB economists forecast inflation to be 3%, and the other half forecast

inflation to be 9%. If the BB uses the average of these two forecasts as its measure of

expected inflation, then at what target should the lending rate be set according to the

Taylor rule? (2 Mark)

c. Now suppose half of BB economists forecast inflation to be 0%, and half forecast

inflation to be 12%. If the BB uses the average of these two forecasts as its measure of

expected inflation, then at what target should the lending rate be set according to the

Taylor rule? (2 Mark)

d. Do you think it is a good idea for BB to strictly use Taylor rule as a basis for setting

policy? Why or why not? (4 Mark)