# Inflation rate vs Monetary policy

2015 exam morning session, Economics

The optimal inflation rate calculated from Taylor’s Rule = 2.35% and the current inflation rate is 2.50%. Why the monetary policy should be loosen?

If the optimal rate is below the current rate, then the central bank should reduce the current inflation rate by reducing the money supply, no? Wouldn’t loosening the monetary policy make the inflation even higher?

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I don’t have access to the 2015 morning session, so I cannot look at the actual exam questions and answers.

The Taylor rule calculates the optimal Fed funds rate, not the optimal inflation rate.

Without more details, I cannot help with your question, unfortunately.

Simplify the complicated side; don't complify the simplicated side.

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If you reduce interest rates, then people will borrow more and there will be more money in circulation

I have same question about this, why the monetary policy should loosen? Based on Taylor Rule, the R optimal is 2.35% and the current neutral rate is 2.5%, so why should monetary policy loosen?

If the optimal rate as dictated by the Taylor Rule is lower than the current rate you should loosen monetary policy - i.e., lower the interest rate.

2.35% < 2.5% (assuming the neutral rate is also the current rate) = lower the current rate by 15bps.

Should also reiterate what Magician said: The neutral rate is the neutral policy rate - not the inflation rate as noted by the original poster. The inflation rate is one component of the Taylor Rule, which dictates the optimal interest rate.

Thanks for the reply, I know the Taylor Rule is NOT the inflation rate but the Optimal rate of IR. So it means loosen monetary policy - reduce the IR? Reduce IR (loose) meaning people can borrow at lower rate, that increases the money supply, and increases aggregate demand.

You got it