## Study on Application of the Taylor Rule

a. Assume the Taylor Rule is as specified in class with a 50-50 weight on the inflation and output gaps. Suppose that the current price level is 149 and one year ago the price level was 147. The equilibrium real interest rate is 2%, and the target inflation rate is 2%. Output is currently 1.28 trillion dollars while potential output is 1.3 trillion dollars. Calculate the Taylor Rule implied fed funds rate. Please round your final answer to two decimal places, e.g. 1.11%

[HINT: you’ll need to calculate the current inflation rate as well as the percentage deviation of output from potential – the output gap – in order to derive the implied fed funds rate]

b. Consider a variation on the usual Taylor rule where there is zero weight on the output gap and full weight (weight = 1) on the inflation gap. Assume the central bank’s goal is to stabilize output. When facing demand shocks, would the use of the Taylor rule tend to be stabilizing (i.e. move the economy closer to potential output), destabilizing (i.e. move the economy further away from potential output), or have an ambiguous effect on the economy, relative to a policy of leaving the interest rate unchanged?

c. Given the same situation in part b, when facing supply shocks, would the use of the Taylor rule tend to be stabilizing, destabilizing, or have an ambiguous effect on the economy, relative to a policy of leaving the interest rate unchanged?