Some economists have proposed that central banks should use the following rule for choosing their target interest rate (r):

where:
p is the average of the inflation rate over the past year y is real GDP as recently measured y * is an estimate of the natural rate of output p* is the central bank’s target rate of inflation which is given as 2 per cent.

a. Explain the logic that might lie behind this rule for setting interest rates. Would you support the use of this rule?

b. Some economists advocate such a rule for monetary policy but believe p and y should be the forecasts of future values of inflation and output. What are the advantages of using forecasts instead of actual values? What are the disadvantages?

Transcribed Image Text:

(y-y") r=2+p+y-y +\p - p) y'