Suppose that inflation is 2 percent, the federal funds rate is 4 percent, and real GDP is 3 percent below potential GDP. According to the Taylor rule, in what direction and by how much should the Fed change the real federal funds rate?

The Fed should decrease the real federal funds rate by 0.5%

Explanation:

The formula according to Taylor can be expressed as;

N=I+R+0.5 (I-I*) + 0.5 (Y-Y*)

where;

N=nominal fed fund rate

I=inflation rate

R=real federal fund rate

I*=target inflation rate

Y-Y*=output gap

In our case;

N=4%=4/100=0.04

I=2%=2/100=0.02

R=unknown=R

I*=assume 2%=2/100=0.02

Y-Y*=-3%=-3/100=-0.03

replacing;

0.04=0.02+R+0.5 (0.02-0.02) + 0.5 (-0.03)

0.04=0.02+R+0-0.015

0.04=R+0.005

R=0.04-0.005=0.035

Change=R-N

Change=0.04-0.035=0.005

The Fed should decrease the real federal funds rate by 0.5%