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.

The correct answer is option A.

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