Assignment Answers

Taylor Rate
Which value should the Taylor rate take when the economy is in equilibrium? The inflation target is
equal to p* = 2% and the equilibrium real interest rate is r* = 2%.

Since the economy is in equilibrium all the macroeconomic indicators such as unemployment,
employment, output, will be at its natural state. Therefore there is no unemployment gap(U=Un).

And with regards to target inflation rate and actual inflation, since they are the replications of
expected price and actual price from the wage and price setting relations. An equilibrium in the
labor market requires the expected price level be equal to the actual price level( ) and the
same rule applies with respect to target and real inflation rates( ).

So Taylor’s rule suggest that the nominal interest rate should be increased by 4%.

Taylor’s rule is intended to keep the price stable by systematically reducing uncertainty and
increasing the credibility of future actions by the central bank.

Okun’s law
Let us suppose that the growth rate of real GDP is equal to 1%. The estimated values for the Okun
relationship are: = 1 and = −2. Which statement concerning the change in the unemployment
rate can you make? What if the parameters are estimated to be = 2 and = −2?

Since we are given only the growth rate of real GDP( ), we are going to use the Okun’s
Difference version. Its formula given by :

We assume that the standard error is zero as it is not given(___). From given coefficients we can
say that the change in unemployment rate is negatively related to the change in GDP growth, which
is in line with Okun’s law. In this first case the slope beta is equal to -2 meaning that each one
percentage point increase in GDP will decrease the change in unemployment rate negatively by two
percentage points.
1) Ut-Ut-1=1+(-2)*1%= -1%
Ut-Ut-1=1+(-2)*2%= -3%

These calculations imply that one additional increase in GDP growth, decreases the change in
unemployment rate by 2%.

2) In this second case we are changing the coefficient alpha( ) from previous equation:
=2, = -2.

Ut-Ut-1=2+(-2)*1%= 0
Ut-Ut-1=2+(-2)*2%= -2

As we can see this change in coefficient alpha( ) only slows down or weakens the effect of
GDP growth on the change in unemployment rate. But our previous statement holds the
same which says every additional change in GDP growth rate will have a negative effect on
the change in unemployment rate by 2 percentage points because the slope( ) has not
changed.