The new chairman of the Ionian Central Bank (ICB) is preparing for her first board meeting. She is expected to recommend a monetary policy for the board to pursue. She decides to use the Taylor rule, which was originally developed for the U.S. Federal Reserve. Ionia’s potential GDP is 100 million drachma, but current GDP is 102 million. What is Ionia’s output gap? Ionia’s output gap: Inflation is running at 6%, but the chairman considers an inflation rate of 3% to be a reasonable goal. What is lonia’s inflation gap? Ionia’s inflation gap: The Taylor rule helps the chairman to determine the target inflation rate. discount rate. O fed funds rate. Calculate this target rate for Ionia, according to the Taylor rule. target rate: The current rate is 4%, so the chairman recommends O selling securities. O buying securities
The correct answer and explanation is:
1. Ionia’s Output Gap:
The output gap is the difference between the actual GDP and the potential GDP, expressed as a percentage of the potential GDP. It is calculated using the formula: Output Gap=Actual GDP−Potential GDPPotential GDP×100\text{Output Gap} = \frac{\text{Actual GDP} – \text{Potential GDP}}{\text{Potential GDP}} \times 100
Substituting the values: Output Gap=102 million drachma−100 million drachma100 million drachma×100=2%\text{Output Gap} = \frac{102 \, \text{million drachma} – 100 \, \text{million drachma}}{100 \, \text{million drachma}} \times 100 = 2\%
Ionia’s Output Gap: 2%.
2. Ionia’s Inflation Gap:
The inflation gap is the difference between the current inflation rate and the target (or goal) inflation rate. It is calculated as: Inflation Gap=Current Inflation Rate−Target Inflation Rate\text{Inflation Gap} = \text{Current Inflation Rate} – \text{Target Inflation Rate}
Substituting the values: Inflation Gap=6%−3%=3%\text{Inflation Gap} = 6\% – 3\% = 3\%
Ionia’s Inflation Gap: 3%.
3. Target Rate According to the Taylor Rule:
The Taylor rule is used to set the target nominal interest rate and is given by: Target Rate=Neutral Rate+0.5(Inflation Gap)+0.5(Output Gap)\text{Target Rate} = \text{Neutral Rate} + 0.5 (\text{Inflation Gap}) + 0.5 (\text{Output Gap})
Here, the neutral rate is generally assumed to be 2%. Substituting the values: Target Rate=2%+0.5(3%)+0.5(2%)\text{Target Rate} = 2\% + 0.5(3\%) + 0.5(2\%) Target Rate=2%+1.5%+1%=4.5%\text{Target Rate} = 2\% + 1.5\% + 1\% = 4.5\%
Target Rate: 4.5%.
4. Recommendation:
The current rate is 4%, which is lower than the target rate of 4.5%. To achieve the target, the ICB chairman should recommend selling securities in the open market. This contractionary monetary policy reduces the money supply, raises interest rates, and helps to control inflation.
Explanation:
The Taylor rule provides a systematic way to adjust interest rates based on economic conditions. By factoring in both the inflation gap and the output gap, it ensures that monetary policy addresses price stability and economic output simultaneously. In this case, the chairman identifies an overheating economy (output above potential) and high inflation, necessitating a higher interest rate. Selling securities reduces excess liquidity, aligns the interest rate with the target, and helps restore economic balance.