Question

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

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

Step-by-step solution

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 =$2+\left(-0.4\right)+0.5\times \left(-2.4\right)-1.0\times 5=-4.6$.

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.