In the Taylor rule, does the target for the federal funds rate respond differently for a recession caused by a decrease in aggregate demand and for a recession caused by a decrease in short-run aggregate supply? Explain whether there is or is not a
difference in how the target for the federal funds rate changes.
The target for the federal funds rate responds differently. The output gap is negative with both recessions, but the current inflation rate and the inflation gap differ. The decrease in short-run aggregate supply will increase current inflation and the inflation gap (current inflation rate minus the target inflation rate). The decrease in aggregate demand will decrease both current inflation and the inflation gap. The target for the federal funds rate will be higher for the recession caused by a decrease in short-run aggregate supply.
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