The next questions refer to the following.
Suppose the central bank follows the Taylor Rule
nominal interest rate = .03 + .5(output gap) + 1.5(inflation rate - .02).
-The real interest rate will be approximately
A) -.01
B) .02
C) .025
D) .05
E) .07

Question

Quizplus · Accepted Answer

Real interest rate = nominal interest rate - inflation rate
Using the Taylor Rule, we get:
Real interest rate = (.03 + .5(output gap) + 1.5(inflation rate - .02)) - inflation rate
Simplifying this expression, we get:
Real interest rate = .03 + .5(output gap) + .5(inflation rate) - .03
Real interest rate = .5(output gap) + .5(inflation rate)
Plugging in the values, we get:
Real interest rate = .5(0) + .5(.02) = .01
Therefore, the real interest rate is approximately .02 (Option B).

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