Now let's discuss a calculation used when studying monetary policy. It's called the Taylor rule. So the Taylor rule, I want to make a note real quick. This is something you generally deal with more in higher-level economic classes, but sometimes they like to mention it here and a lot of times it's just knowing what it is. You might not even have to do these calculations, so I would suggest double-checking with your professor. But let's go through it just in case you need to know it. The Taylor rule links the Federal target the Fed's target for the Federal Funds Rate to several economic variables. Okay? So we're thinking about what is the Federal Funds Rate that the Fed wants to set and this goes back to that money market, right? What is that equilibrium interest rate that the Fed wants? So remember that the federal fund rate is the interest rate banks give to other banks on overnight loans. So this is generally when they need to meet reserve requirements. They need a certain amount of reserves for their level of deposits and they get a short-term loan just to meet these requirements. And those loans are given at this interest rate, the federal funds rate. So the Fed is regularly making decisions to get to the correct, in quotations, Federal Funds Rate, right? They want to set the Federal Funds Rate where they think is best for the economy. Now, I want to make a note about the Taylor rule is that the Fed does not use the Taylor rule. This is an approximation that this smart dude, John Taylor made. He made this mathematical approximation of how the Fed sets their target funds rate the target federal funds rate. Okay? So let's get into the calculation now. So the target Federal Funds Rate is going to be composed of these variables here. First, it's the current inflation rate. What is the inflation rate currently in the economy? Plus the equilibrium real federal funds rate. So this is also going to be basically the equilibrium real federal funds rate is adjusted for inflation. So the current inflation rate is equal to actual inflation and here we've got equilibrium real. And this is generally given to you in the problems. It's going to have to be given and it's generally set as 2% is the target that the Fed has for this number. So equilibrium real federal funds rate and notice, this might look complicated but they're going to have to give you all of this information in the problem. There's really not so much math that goes on. So the sum of the first two terms is where the federal funds rate would be at long-run equilibrium. That's where they want it to be, and it's generally 4%. They generally target for 2% in inflation and 2% in equilibrium there as well. Now, the last two terms make it look a little complicated, but it's not that bad. The inflation gap, it's the difference between the current inflation and the target and the Fed usually sets the target at 2%. The target is generally 2% for inflation. So the inflation gap equals current inflation minus target. So you can get a negative number here. You can get a negative current minus target for the inflation gap and you can also get a negative number for the output gap as well. So the output gap deals with GDP. So we've got the inflation gap and then the output gap which is the difference. It equals the current GDP minus the potential GDP. The potential GDP of the economy, right? What is the total GDP that they could have?
Taylor Rule - Online Tutor, Practice Problems & Exam Prep
Taylor Rule
Video transcript
Taylor Rule
Video transcript
Alright. Let's try this example for the Taylor rule. Use the Taylor rule to estimate the target federal funds rate. The current inflation rate in the economy is 4% and the equilibrium real federal funds rate is 2%. The target inflation is 2%. Real GDP is currently above potential GDP by 1%. There are a lot of numbers there, but it's just asking if you can apply this formula. So, the target federal funds rate is calculated as follows: the target federal funds rate is equal to the current inflation plus the equilibrium real federal funds rate, which they have also given to us. They have given us all these numbers, plus half of the inflation gap. I'll put IG plus half of the output gap, OG, as well. Okay? So they have given us information about all these numbers. We just have to figure out what they are and put them in the correct place. They told us the current inflation rate is 4%, right? 4% for the current inflation rate plus the equilibrium real federal funds rate is 2%. So, they have given us these numbers already. Now, we need to think about the inflation gap and the output gap. So, remember, the inflation gap is equal to the current inflation minus the target inflation, which we have information about both. They told us the current inflation is 4%, and the target inflation right here is given to us as 2%. So our inflation gap is equal to 2% right there. 2% is going to be our inflation gap. So over here, we'll have 0.5 times 2% for our inflation gap. And finally, we need our output gap and they told us straightforwardly. They told us that the output, real GDP, is currently above potential GDP by 1%. So if real GDP is above potential GDP, our output gap, remember, our output gap is current minus potential. So, right now, they told us that the current is above potential by 1%. So the output gap is equal to that 1% that we are above potential. They didn't tell us both numbers in that case; they just told us what the difference is, the 1%. So, this would be 0.5 times the output gap of 1%, and we just have to wrap this up here. So the target federal funds rate is going to equal, I'll do it over here, 4% plus 2% plus 0.5 times 2% plus 0.5 times 1%, this comes out to 7.5% as the target federal funds rate in this example.
So, what's happening here is we've got high inflation and our economy is hot, we're producing past our potential GDP, so they want to set a high interest rate to de-incentivize investment and de-incentivize aggregate demand and bring that spending down to a more reasonable level. 7.5% would be the rate approximate for the target federal funds rate.
Is it possible for the Taylor Rule to suggest a target federal funds rate to be negative? Assume the current inflation rate is 0%, the equilibrium real federal funds rate is 2%, and the target inflation rate is 2%.
