Question

How would an unexpected change in the equilibrium real fed funds rate be an argument against using a Taylor rule for monetary policy implementation?

Short answer

The Taylor rule says when inflation or GDP growth rates are higher than intended, the Federal Reserve should raise interest rates but when the economy is booming, the reasoning is reversed.

Step-by-step solution

Content Introduction

When inflation is high or employment levels are over full employment, the Federal Reserve should raise interest rates, according to Taylor's rule. When inflation and employment are low, however, the Taylor rule suggests that interest rates should be reduced.

Content Explanation

The Taylor rule is a formula that can be used to anticipate or direct central banks' interest rate changes in response to economic events. When inflation or GDP growth rates are higher than intended, Taylor's rule suggests that the Federal Reserve should raise interest rates.

According to the hypothesis, decreasing rates lowers borrowing costs, which encourages businesses to take out loans to hire more workers and expand output. When the economy is booming, the reasoning is reversed.