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Chapter 16: Q8. (page 347)

In 2009, the inflation rate reached a negative 0.4 percent while the unemployment rate hit 10 percent. If the target inflation rate was 2 percent and the full-employment rate of unemployment was 5 percent, what value does the Taylor Rule predict for the Fed’s target interest rate back then? Would that rate have been possible given the zero lower bound problem?

a. negative 4.6 percent, not possible.

b. positive 0.4 percent, possible.

c. negative 5.6 percent, not possible.

d. positive 6.4, possible.

Short Answer

Expert verified

The correct option is‘ a. negative 4.6 percent, not possible’.

Step by step solution

01

Step 1. Reason for the correct option 

The Taylor rule suggests the following formula for the Fed’s target interest rate:

Fed target interest rate = 2 + current actual inflation rate + 0.5 × inflation gap – 1.0 × unemployment gap,where inflation gap = actual – target inflation rate, and

Unemployment gap = actual – target unemployment rate.

Therefore,

Inflation gap = -0.4-2=-2.4

unemployment gap = 10-5=5, and

target Interest rate =2+-0.4+0.5×-2.4-1.0×5=-4.6.

The zero-bound problem occurs when the interest rates are very near to zero or zero itself. As the rates are very far from zero, there will be no zero-bound problem in this case.

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Most popular questions from this chapter

Explain the links between changes in the nation's money supply, the interest rate, investment spending, aggregate demand, real GDP, and the price level.

In the tables that follow, you will find consolidated balance sheets for the commercial banking system and the 12 Federal Reserve Banks. Use columns 1 through 3 to indicate how the balance sheets will read after each transaction a to c is completed. Do not cumulate your answers; that is, analyze each transaction separately, starting in each case from the numbers provided. All accounts are in billions of dollars.


\(

Consolidated Balance Sheet:

All commercial banks

1

2

3

Assets


Reserve

Securities

Loans




33

60

60





150

3














Liabilities and net worth:



Checkable deposits

Loans from federal reserve banks


\)

Consolidated Balance Sheet:

The 12 Federal Reserve Banks

1

2

3

Assets


Securities

Loans to commercial banks




60

03





33













Liabilities and net worth:



Reserves of commercial bank


Treasury deposits

Federal reserve notes

3

27






a. A decline in the discount rate prompts commercial banks to borrow an additional \(1 billion from the Federal Reserve Banks. Show the new balance-sheet numbers in column 1 of each table.

b. The Federal Reserve Banks sell \)3 billion in securities to members of the public, who pay for the bonds with checks. Show the new balance-sheet numbers in column 2 of each table.

c. The Federal Reserve Banks buy $2 billion of securities from commercial banks. Show the new balance-sheet numbers in column 3 of each table.

d. Now review each of the previous three transactions, asking yourself these three questions: (1) What change, if any, took place in the money supply as a direct and immediate result of each transaction? (2) What increase or decrease in the commercial banks' reserves took place in each transaction? (3) Assuming a reserve ratio of 20 percent, what change in the money-creating potential of the commercial banking system occurred as a result of each transaction?

The Taylor Rule puts _________ as much weight on closing the unemployment gap as it does on closing the inflation gap.

a. just

b. twice

c. half

d. ten times

What is the basic determinant of (a) the transactions demand and (b) the asset demand for money? Explain how to combine these two demands graphically to determine total money demand. How is the equilibrium interest rate in the money market determined? Use a graph to show how an increase in the total demand for money affects the equilibrium interest rate (no change in the money supply). Use your general knowledge of equilibrium prices to explain why the previous interest rate is no longer sustainable.

What is the basic objective of monetary policy? What are the major strengths of monetary policy? Why is monetary policy easier to conduct than fiscal policy?
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