Assume an economy with an AE curve with a slope of 1 where a one percent change in real interest rates changes real GDP by 1 percent with a one year lag; and a slope to the short run Phillips curve of 1 where a 1 percentage point increase in real GDP increases inflation by 1 percent, also with a one year lag. From Okun's law for this economy a 1 percent change in real GDP changes the unemployment rate by .5%. The natural rate of unemployment for this economy is 5%. The neutral real rate of interest rⁿ = 3.0 %/ and the target rate of inflation Πt = 2%.

Assumes that policy makers inherit an economy at its natural rate of unemployment (5%), 6 percent inflation, and decide to use a hard Taylor rule of:

r = 3% + 1.0 (output gap) + 1.0 (Π - 2%)

Fill in the following table assuming that policy makers have a correct model of the economy, follow the Taylor rule, and the economy has the two one period lags. Remember that in each year the policy choice for the real interest rate changes. (Your policy choice in year 0 affects GDP in Y in year 1 and how that policy affects GDP in year 1 affects inflation in year 2.

Hint. Use the Taylor rule to pick r in period 0 based on information in table. That r chosen for year 0 will have an impact on Y (and u based on Okun's law) in year 1, but will have no impact on inflation until year 2 depending on the output gap that opens up in year 1.

Year      Policy Choice for r         Y        Π        u

0                           100      6        5

1                                     6

2

3

4