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True or False: According to the Taylor principle, if actual inflation rises by 1% over...

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lilylee | Student, College Freshman | Salutatorian

Posted July 27, 2013 at 3:39 PM via web

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True or False:

According to the Taylor principle, if actual inflation rises by 1% over target inflation, the the Fed should raise the federal funds by 2% to make sure the real federal funds rate rises which is referred to as "leaning against the wind".

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted July 27, 2013 at 4:23 PM (Answer #1)

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This statement is true.  At least, it is true if we read the statement to mean that the central bank should raise the interest rate by 2% over the target rate of inflation.  In other words, if the central bank wanted 2% inflation and got 3%, it should raise the interest rate by 4%.   It is not necessary that the central bank should increase the interest rate by exactly twice the amount by which the inflation rate increases.  However, the Taylor rule does advocate that the central bank should increase the interest rate by more than the increase in the rate of inflation.

The Taylor rule is very much concerned with reducing inflation.  It wants to ensure that inflation remains low.  Therefore, it prescribes that the central bank should “lean against the wind.”  What that means is that the central bank should raise the interest rate by more than the rate of inflation has increased.  Therefore, this statement is true.

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