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The Community of Paci?c States (CPS) operates a Taylor rule of interest rates = 5% + A X (output gap) + B X (in?ation - in?ation target) In?ation is determined by a Phillips curve so that in?ation = in?ation target + 0.5 X output gap last year And interest rates impact on the output gap so that output gap = -0.5 X (interest rates last period - 5%) The output gap is currently 2% and in?ation is 3% with a target of 2%. The central bank of the CPS is considering two alternative policy rules. One sets A = 0.75 and B = 1, whereas the other sets A = 0.25 and B = 2.
(a) Compare the behavior of interest rates, in?ation, and output over the next ?ve years for both rules.
(b) How does the volatility of in?ation and output vary in each case?
(c) Examine how your answers change when the slope of the Phillips curve and the sen- sitivity of interest rates change.
(d) How would your answers change if in?ation = last year's in?ation + 0.5 X output gap last year.
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