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)?
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