Taylor Rule: Assume An Economy With An AE Curve With A Slope

Taylor Ruleassume An Economy With An Ae Curve With A Slope Of 1 Wh

Assume an economy with an aggregate expenditure (AE) curve with a slope of 1, where a one percent change in real interest rates results in a one percent change in real GDP with a one-year lag. This economy is also characterized by an output gap Phillips curve, where a one percentage point change in the output gap influences inflation with a one-year lag. According to Okun’s law, a 1 percent change in real GDP alters the unemployment rate by 0.5%. The natural rate of unemployment is 5%, and the neutral real interest rate, r_n, is 3%. The target inflation rate, ï_T, is 2%. Policymakers start with an economy at its natural unemployment rate (5%) and 6% inflation in year 0, choosing to follow an aggressive Taylor rule: r = 3% + 1.0 (Y - Y)/Y + 1.0 (Î – 2%). The goal is to determine the appropriate policy interest rate, output gap, unemployment rate, and inflation over several years, considering the lags in the economy’s responses and the influence of the Taylor rule.

Paper For Above instruction

The Taylor rule is a widely recognized monetary policy guideline that prescribes how central banks should set interest rates based on deviations of actual inflation and output from their target levels (Taylor, 1993). In the context of this exercise, the Taylor rule is modified to account for the economy's specific dynamics, including the one-year lags in how changes in real interest rates affect GDP and inflation, alongside Okun’s law relating unemployment to GDP. This setting provides an insightful framework to analyze how aggressive policy prescriptions can influence macroeconomic stability over time.

Initially, the economy is at its natural unemployment rate of 5%, with inflation at 6%. Using the Taylor rule, policymakers determine the interest rate for year 0 based on the inflation gap (inflation minus target) and the output gap (deviation of GDP from its potential). Given that the economy starts at equilibrium, the initial real interest rate, r₀, is calculated as follows:

r₀ = 3% + 1.0 × (Y₀ - Y)/Y + 1.0 × (6% - 2%) = 3% + 0 + 4% = 7%

This elevated interest rate is intended to reduce inflation from 6% toward the 2% target but will also impact output and unemployment through the economy's lagged responses. Specifically, the increase in interest rates is expected to decrease GDP in year 1 as per the slope of the AE curve, with a 1% rise in r leading to a 1% decrease in GDP after one year. Consequently, the output gap in year 1 is calculated based on the change in GDP relative to potential GDP, which initially is at equilibrium (no gap).

Applying Okun's law, a 1% decrease in GDP results in a 0.5% increase in unemployment. Therefore, the unemployment rate in year 1 will be:

u₁ = 5% + 0.5% × (decrease in GDP) = 5% + 0.5% × 1 = 5.25%

The reduction in GDP and the rising unemployment exert downward pressure on inflation, but given the one-year lag from output gap to inflation via the Phillips curve, the inflation rate in year 2 will adjust depending on the output gap realized in year 1. As the adjusted interest rate reduces GDP in year 1, later periods will witness inflation declining toward the target of 2%, assuming no other shocks.

Repeating this process for subsequent years involves recalculating the interest rate using the Taylor rule based on updated inflation and output gap information. The interest rate in year 1 (r₁) depends on the inflation in year 1 and the output gap (which now exists due to the interest rate change), affecting GDP in year 2. The chain of causality underscores the importance of lagged responses in monetary policy design.

Overall, the aggressive Taylor rule in this scenario aims to stabilize inflation near the target while managing output and unemployment. The lags introduce a delay in the policy’s effectiveness, necessitating forward-looking policymaking. As the economy responds over time, the interest rates adjust accordingly, highlighting the dynamic interplay between policy actions and macroeconomic variables.

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