The question asks the potential weakness of following Taylor Rule given the statitics in the question.
Could someone please explain the solution in simple baby language (part B(ii) – i dont get it. I have no issues with the computation of the target short term rate.
3.5 + 0.5 (0.3 - 2.2) + 0.5 (4.4 - 2) = 3.75
Current short term rate is 5.5%.
inflation forecast is 4.4% and inflation target is lower @ 2.0%
GDP Forecast is 0.3% while GDP target is 2.2%.
The interest rate reduction to 3.75% based on the Taylor rule will increase the GDP due to the stimulus, but it will also increase Inflation further away from the target inflation rate.
Hope it is babyish enough.
I don’t have the question in front of me, but I’ll venture a guess… If the central bank is expected to raise rates primarily because GDP is forecasted to rise over trend, and that forecast doesn’t come true, and in fact GDP declines below trend… the central bank would have raised rates during a time it needed to lower rates… all hell breaks loose, people go crazy, the world ends as we know it.
thanks guys. i have re-read my Taylor rule notes…sorted.