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Suppose the initial inflation rate and inflation target are both 2%, that the real federal funds rate is 2%, and that the economy is at the full employment level of output. According the Taylor Rule, the federal funds target should be . Suppose now that the inflation rate changes to 6%. The Taylor Rule now prescribes that the federal funds target should be

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Answer:

a. 4%

b. 10%

Explanation:

1. Federal funds target = Real Federal funds rate + Inflation rate + 1/2( inflation gap) + 1/2(output gap)

Inflation gap = Current inflation - inflation target = 2% - 2% = 0

Economy is at full employment so output gap is 0.

= 2% + 2% + 1/2(0) + 1/2 (0)

= 4%

2. Federal funds target = Real Federal funds rate + Inflation rate + 1/2( inflation gap) + 1/2(output gap)

= 2% + 6% + 1/2(6% - 2%) + 1/2(0)

= 10%

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