17.4 The Taylor Rule #Notebook

17.4 The Taylor Rule #Notebook

fft = π + ff*r + 1 ⁄ 2(π gap) + 1 ⁄ 2(Y gap)

Federal funds target = inflation + the real equilibrium fed funds rate + 1/2 inflation gap +1/2 output gap

fft = federal funds target

π = inflation

ff*r = the real equilibrium fed funds rate

π gap = inflation gap (π – π target)

Y gap = output gap (actual output, GDP − output potential)

Globalization makes it increasingly important for the Fed and other central banks to look at world inflation and output levels to get domestic monetary policy right.

Foreign exchange rates can also flummox central bankers and their policies. Increasing or decreasing interest rates will cause a currency to appreciate or depreciate in currency markets. 

Because the value of a currency directly affects foreign trade, when a currency is strong or weak relative to other currencies, imports will be stimulated or contracted because foreign goods will be cheap or expensive.

Some countries with economies heavily dependent on foreign trade have to be extremely careful about the value of their currencies.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.