If the inflation gap seems to be zero and real GDP rises with one percent above potential GDP, the Fed should raise the real federal funds rate by half a point.
What is Taylor rule?
- The rule calls for a higher federal funds rate when inflation exceeds the Fed's target, and a lower rate when inflation is low.
- The Taylor rule is an equation proposed by John Taylor in a 1993 paper that prescribes a value for the federal funds rate—the short-term interest rate targeted by the Federal Open Market Committee (FOMC)—based on inflation and economic slack measures such as the output gap or unemployment gap.
- An inflationary gap occurs when demand for goods and services exceeds supply due to factors such as increased overall employment, increased trade activity, or increased government spending. In this context, real GDP may exceed potential GDP, resulting in an inflationary gap.
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