If real GDP is 2% below potential GDP, and the inflation rate is 1%, then according to the Taylor rule, the Fed should make the real federal funds rate:
A) Decrease by 1.5%
B) Decrease by 3%
C) Increase by 3%
D) Decrease by 1%

Question

Quizplus · Accepted Answer

According to the Taylor rule, the Fed should adjust the real federal funds rate based on the output gap and inflation. With real GDP 2% below potential, the output gap is -2%. The Taylor rule suggests decreasing the rate by 1.5 times the output gap, which is -3%. However, the inflation rate is 1%, so the real rate should decrease by 1.5% to accommodate both factors.

If Real GDP Is 2% Below Potential GDP, and the Inflation