Setting interest rates is among the most consequential decisions a central bank makes -and one of the most contested.To make the trade-off between price stability and full employment transparent, central banks from Frankfurt to Mumbai have at various times turned to simple rules that link the policy rate to current inflation, an inflation target, and the gap between actual and potential output.The mechanical clarity is appealing, but the coefficients on each term embed value judgements about the central bank’s response.
The rule below, and the questions that follow, examine how those judgements shape outcomes.
A central bank uses the following rule to set its interest rate:
i = r* + π + 0.5(π − π*) + 0.5(y − y*)
where
i = nominal interest rate,
r* = long-run real interest rate,
π = current inflation,
π* = inflation target,
y = current real output,
y* = potential output,
(y − y*) = the output gap.
For all parts of this question, assume the following values for the central bank’s economy:
r* = 2%
π* = 2%
π = 5%
(y − y*) = − 1% (output is 1 percentage point below potential)
a)A second economy is identical except that its output is 2 percentage points above potential rather than 1 percentage point below.
By how many percentage points does the rule prescribe a higher policy rate in this second economy compared with the first? (2 marks)
b)The Taylor Principle states that a central bank must raise nominal rates by more than one-for-one with inflation to achieve real tightening. Does raising the coefficient from 0.5 to 1.5 satisfy the Taylor Principle? Why/why not? (2 marks)