Continuing to work with a 2% inflation target, a 1999 version of the Taylor Rule and an initial nominal policy rate of 1.5%, now consider the impact of including a variable risk premium that is typically positive, meaning that the market interest rate is usually above the central bank policy rate. In the following questions, assume the normal (natural) risk premium is 100bp, the economy has a negative output gap (minus 1%), the actual risk premium is 300bp, the economy’s natural real market interest rate is 2% and that both actual and expected inflation is 1%. 5a) what nominal policy rate would you recommend? 5b) what is the natural nominal policy interest rate? 5c) how does the new market real interest rate compare with its initial level?
Continuing to work with a 2% inflation target, a 1999 version of the Taylor Rule and an initial nominal policy rate of 1.5%, now consider the impact of including a variable risk premium that is typically positive, meaning that the market interest rate is usually above the central bank policy rate. In the following questions, assume the normal (natural) risk premium is 100bp, the economy has a negative output gap (minus 1%), the actual risk premium is 300bp, the economy’s natural real market interest rate is 2% and that both actual and expected inflation is 1%.
5a) what nominal policy rate would you recommend?
5b) what is the natural nominal policy interest rate?
5c) how does the new market real interest rate compare with its initial level?
5d) what nominal policy rate would the Taylor Rule recommend if the negative output gap then widened to minus 2% and both current and expected inflation fell to zero? (other factors, including the risk premium remaining unchanged)
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