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 Ionia's inflation gap?
Ionia's inflation gap: %

The Taylor rule helps the chairman to determine the target
- fed funds rate.
- discount rate.
- inflation rate.

Calculate this target rate for Ionia, according to the Taylor rule.
target rate: %

The current rate is 4%, so the chairman recommends
- buying securities.
- selling securities.

Ionia's output gap: 2%
Ionia's inflation gap: 3%
- fed funds rate
target rate: 10.5%
- selling securities

Explanation:

The Taylor rule was developed as a simple way for the Federal Reserve to determine the appropriate federal funds rate target. The federal funds rate is the interest rate one bank charges another for overnight loans. The rate the Fed charges for last resort loans is the discount rate.

    federal funds rate target = 2 + inflation + (0.5 × inflation gap) + (0.5 × output gap)

Start by calculating the gaps. Be sure to subtract the target value from the current value. The GDP gap will be stated as a percentage of potential GDP.

output gap = current GDP − potential GDP / potential GDP
    =102 million − 100 million / 100 million
    =2 million / 100 million
    =0.02
    =2%

inflation gap = current inflation − inflation target
    =6% − 3%
    =3%

Now, use these gap numbers in the full equation.

federal funds rate = 2 + inflation + (0.5 × inflation gap) + (0.5 × output gap)
    = 2 + 6 + (0.5 × 3) + (0.5 × 2)
    = 10.5

The current federal funds rate is 4%, so the central bank needs to bring the rate up to 10.5%, which can be done by selling Treasury securities. This will lower the price of securities and pull the interest rate up.