Plutonia uses the Taylor rule to set the short term interest rate at which banks lend to each other
Compute the short term interest rate that should be set in Plutonia if the inflation target is 2%, the long-term target for the interest rate is 3%, the current rate of inflation is 5%, and output is 5% below its trend.
According to the Taylor rule, the short-term interest rate = Long-term target + 1.5 × + 0.5 (output gap). In this case, the inflation target is 2%, the long-term target for this interest rate is 3%, the current rate of inflation is 5%, and the output gap is -5%. Therefore, the short-term interest rate = 3% + 1.5 × (5% - 2%) + 0.5 (-5%) or 5%.
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Once an equilibrium is achieved, it can persist indefinitely because
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