Suppose the Federal Reserves is following the Taylor rule. The economy is thought to be 2 percent below potential (i.e., the output gap is2 percent), and the inflation rate was 3 percent over the past year. The federal funds rate is currently 3 percent. The equilibrium real fed funds rate is 3 percent and the weights on the output gap and inflation gap are 0.5 each. The inflation target is 1 percent.

a) Is the federal funds rate currently too high or too low? By how much? Show your work.

b) Suppose a year has gone by, output is now 3 percent above potential, and the inflation rate was 4.5 percent over the year. What federal funds rate should the Federal Reserve now set (assuming the inflation target does not change)? Show your work.

c) What challenges do policymakers and researchers face in using the Taylor rule?