HM: 1. Why does the Fed target 2% inflation? 2. The formula for the Taylor rule is FF ＝ I + FF* + 0.5 * (I – I*) + 0.5 * (Y – Y*) where FF is the federal funds rate, FF* is the equilibrium real funds rate, I is the inflation rate, I* is the target inflation rate, and Y – Y* is the potential gap. Scenario 1: Assume potential growth is 2%, the natural rate of unemployment is 5%, and the potential gap is -1.5% initially. Also note that core inflation initially is running at 1½% and the unemployment rate is 6%. If the economy grows at 3% over the next two years… Scenario 2: Assume potential growth is 2%, the natural rate of unemployment is 5%, and the potential gap is +1½% initially. Also note that core inflation initially is running at 3½% and the unemployment rate is 4%. If the economy falls into recession and declines by 2% over the next two years… Scenario 3: Assume potential growth is 2%, the natural rate of unemployment is 5%, and the potential gap is 0% initially. Also note that core inflation initially is running at 1½% and the unemployment rate is 5%. If the economy grows at 2% over the next two years… a. Using the three scenarios above, an assumed equilibrium real funds rate of 1%, and an inflation target of 2%, what would the Taylor Rule say the policy rate should be? b. How would the results change for each scenario if the Taylor Rule was balanced FF ＝ FF* + (I – I*) + (Y – Y*) ? Discussion: Write a paragraph summarizing Yellen’s views on the drivers of inflation (“Inflation Dynamics and Monetary Policy”). How does policy influence expectations?
