Suppose the federal funds rate rises by 0.5 percent. If the Taylor rule is correct, this might be because output is: Group of answer choices a)1 percentage point below potential output. b)0.5 percentage points below potential output. c)0.5 percentage points above potential output. d)1 percentage point above potential output.

Suppose the federal funds rate rises by 0.5 percent. If the Taylor rule is correct, this might be because output is:
Group of answer choices
a)1 percentage point below potential output.
b)0.5 percentage points below potential output.
c)0.5 percentage points above potential output.
d)1 percentage point above potential output.

Answer

• c)0.5 percentage points above potential output.
  Explanation:
  According to the Taylor rule, the central bank should increase interest rates when inflation is above target or when GDP is too high above the potential. This rule is based on three factors which are targeted versus actual inflation, full vs actual employment levels and lastly, short-term interest rates. By raising interest rate, less money is borrowed, decreased money supply and consumer spending decreases, which decreases output to match the potential output.