Question

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%

The answer is A. Decrease by 1.5%. Give a detailed explanation why.

Answer 1

The correct answer is option A.

Step-by-step explanation:

The Taylor rule was given by John Taylor. It states that a 1% increase in the inflation rate should cause the banks to increase the interest rate by more than 1%.

Real GDP is 2% below potential GDP.

The inflation rate is 1%.

According to the Taylor rule, the real federal funds rate should be

= Inflation rate - 0.5 (Real GDP gap - Inflation rate)

= 2 - 0.5 (2-1)

= 2 - 0.5

= 1.5