) Suppose that monetary policymakers employ the Taylor rule to set the fed funds rate. Assume that the weights on both the inflation and output gaps are 0.5, the equilibrium real fed funds rate is 2%, the inflation rate target is 2%, and the output gap is 1%. Suppose half of Fed economists forecast inflation to be 3%, and half of Fed economists forecast inflation to be 5%. If the Fed uses the average of these two forecasts as its measure of inflation, then at what target should the fed funds rate be set according to the Taylor rule

Case 1. Federal funds rate target is 9%

Case 2. Federal funds rate target is 9%

Explanation:

As we know that:

Federal funds rate target = Inflation rate + Equation real fed funds rate +

1/2 * Inflation Gap    +     1/2 * (Output Gap)

Here

Equation real fed funds rate is 2%

Output Gap is 1%

Case 1. Inflation rate target is 3%

So

Inflation Gap = 3%  -  2% = 1%

So by putting values, we have:

Federal funds rate target = 3% + 2% + 1/2 * (1%) + 1/2 * (1%)

= 6%

Case 2. Inflation rate target is 5%

So

Inflation Gap = 5%  -  2% = 3%

So by putting values, we have:

Federal funds rate target = 5% + 2% + 1/2 * (3%) + 1/2 * (1%)

= 9%

The Federal Reserve seeks to control inflation by influencing interest rates. When inflation is too high, the Federal Reserve typically raises interest rates to slow the economy and bring inflation down.

Explanation:

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