Reference no: EM13110512

Question 1.Suppose that the economy is thought to be 2 percent above potential (that is, the output gap is 2 percent) when potential output grows 4 percent per year. Suppose also that the Fed is following the Taylor rule, with an inflation rate of 2 percent over the past year. The federal funds rate is currently 3 percent. The equilibrium real federal 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 that a year has gone by, output is now just 1 percent above potential, and the inflation rate was 1.5 percent over the year. What federal funds rate should the Fed now set (assuming that the inflation target does not change)? 


Question 2.Suppose that the Fed's inflation target is 2%, potential output growth is 3.5%, and velocity is a function of how much the interest rate differs from 5%: % triangle v=0.5x(i-5)

Suppose that a model of the economy suggests that the real interest rate is determined by the equation:
r =8.5-% triangle Y
where Y is the level of output, so %triangleY is the growth rate of output. Suppose that people expect the Fed to hit its inflation target.
A: Calculate the optimal money growth rate needed for the Fed to hit its inflation target in the long run.

B: In the short run, if output growth is just 2% for two years and the equation determining the real interest rate changes to r = 4.5- %triangleY, what money growth rate should the Fed aim for to hit its inflation target in that period?
C: If the Fed instead maintained the money growth rate froom part A, what is likely to happen to inflation?
D: Which policy do you think is better in the short run?which is better in the long run?