Assignment # 6: Due Tuesday, October 22.

Use Taylor's Rule to predict the course of the Federal Funds rate over the period from 1981 to 2001. The data are available at TaylorRuleData.xls, which is given on the course web page with this week's assignment. The form of the rule you should use is:

Federal Funds Rate = [inflation] + 0.5 x [inflation - target inflation] + 0.5 x [GDP Gap] + [Real Federal Funds Rate]

where:

TARGET INFLATION = 2.0

REAL FEDERAL FUNDS RATE = 2.0

GDP GAP = ((Real GDP/Real Potential GDP) - 1)*100

In other words, the percentage deviation of GDP from its potential level

INFLATION = Percent Change in one of the four price measures given in the data set.

Do the Following:

(1)  Provide predictions of the Federal Funds rate for each of the four price measures.

(2)  Compare your results with the actual Federal Funds rate over this period. How well does the rule do in predicting the Federal Funds rate? Which measure(s) of inflation provides the best prediction of the actual Federal Funds rate over this period?

(3)  Optional: If you have time, you might try carrying the exercise out into 2002 for one of the price measures (perhaps the one that has given the best predictions in the past). You'll have to obtain data for this year (or provide your own forecasts), and come up with an estimate of potential GDP (you might just apply a growth rate of, say, 3.5 percent to last year's potential GDP to get this year's potential GDP).