Final answer:
The Taylor Rule suggests setting a lower nominal federal funds rate when real GDP is below its natural level and a higher one when inflation exceeds 2 percent. It is used by central banks to balance economic growth and inflation by adjusting interest rates based on economic indicators.
Step-by-step explanation:
According to the Taylor Rule, when real GDP is below its natural level, the nominal federal funds rate should be lower, and when inflation exceeds 2 percent, the nominal federal funds rate should be higher.
The Taylor Rule is a monetary policy rule that prescribes how a central bank like the Federal Reserve should set short-term interest rates in response to changes in inflation and economic output. When the real GDP falls below the potential or natural level, it suggests weak economic activity that could benefit from lower interest rates to stimulate borrowing and spending. Conversely, when inflation rates climb above a target level, in this case, 2%, the Taylor Rule advises increasing interest rates to cool down the economy and prevent runaway inflation.
Given historical contexts, such as the measures taken in the late 1990s and early 2000s, the Federal Reserve aimed to maintain inflation rates within certain limits, adjusting the federal funds rate accordingly to manage economic stability.