Suppose that real GDP falls to 2 percent below potential GDP.Then,according to the Taylor rule,the Fed should reduce the federal funds,relative to the current rate of inflation,by:
A) ½ percentage point.
B) 1 percentage point.
C) 2 percentage points.
D) 4 percentage points.

Question

Quizplus · Accepted Answer

According to the Taylor rule, the appropriate adjustment to the federal funds rate in response to a decline in real GDP below potential GDP is equal to one-half of the estimated output gap, i.e. the difference between actual and potential GDP as a percentage of potential GDP. Therefore, if real GDP falls to 2 percent below potential GDP, the output gap would be 2 percent, and the Fed should reduce the federal funds rate by one-half of this, or 1 percentage point.

Suppose That Real GDP Falls to 2 Percent Below Potential