II. Problems - You have to show your work. No credit without an explanation (20 marks each).

The Taylor rule for setting optimal interest rates is given by:

rt = r + p + (p t p ) + xt where rt is the desired nominal interest rate, r is the natural real interest rate, p is the inflation target

and xt is the output gap (difference between current and capacity output).

(a) Explain what the constraints on the parameter should be. (5 marks)

(b) Explain what should be the sign of coefficient and why. (5 marks)

(c) How would the equation be different for the European Central Bank (ECB) and the US Federal Reserve (Fed). (5 marks)

(d) How would the equation change if the inflation target is increased, i.e. central banks announce they are willing to accept more inflation before they react with monetary policy? (5 marks)