Taylor Rule - Relationships between GDP and Inflation
This is referring to the 2009 Mock Q5) B) ii)
Excerpt from CFAI answer:
Roptimal = 3.5 + [0.5 x (0.3 – 2.2) + 0.5 x (4.4 – 2.0)] = 3.75%
Rcurrent = 5.5%
“The Taylor rule suggests the Bank of England should target a short-term interest rate of 3.75% versus a current short-term interest rate of 5.5%. The most likely potential negative economic result of the Bank of England following the Taylor rule is increased inflation. Since the forecast inflation rate of 4.4% is currently above the target inflation rate of 2.0%, a cut in the interest rate could cause the inflation rate to rise even further away from the target inflation rate. Lowering short-term rates will stimulate output by lowering corporations’ cost of capital.”
Can someone explain to me why decreasing the target rate will further increase inflation? This is due to the fact that inflation forecast is above trend but GDP forecast is below trend.
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