Macroeconomics

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Economist John Taylor has suggested that the Fed use the following rule for choosing its target for the federal funds interest rate (r):

r= 2% + ð + 1/2 (y-y*) / y* + 1/2 (ð - ð*),

Where ð is the average of the inflation rate over the past year, y is real GDP as recently measured, y* is an estimate of the natural rate of output, and ð* is the Fed's goal for inflation.

a. Explain the logic that might lie behind this rule for setting interest rates. Would you support the Fed's use of this rule?

b. Some economists advocate such a rule for monetary policy but believe ð and y should be the forecasts of future values of inflation and output. What are the advantages of using forecasts instad of actual values? What are the disadvantages?

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