Should we correct mom when she wants to call or go see her mother, who has been deceased for many years?

Is this her ONLY sign of a failing memory or is it part of a pattern of forgetting important things? If it is the only thing she can't seem to remember I would probably try to remind her that her mother is dead and then quickly get her an appointment to be screened for dementia. If it is a clear pattern of mixing lots of people up, getting upset when she is reminded of her mistake, etc I'd make some vague reference to seeing her "some other time." My mother had lots of memory loss and would forget her mother was dead and would mix me up (daughter) with my daughter (her granddaughter) Usually we'd just let it go but sometimes would give a gentle reminder of which of us was which (Oh, I'm Joy, K is at college right now. She'll be home in a few weeks." ) We tried to make it as natural as possible and never drew attention to her error and often just let it go by. I had an aunt who recognized that she had lost track of people and things and would ask multiple times during a conversation, "Now, what did you say your name was?" or "Whose child are you?" She was clearly interested in receiving corrections and they didn't upset her at all.

I agree, this is not normal age decline. Mom needs a good physical. Tests and labs to rule out anything physical. A good neurological exam to she if she has Dementia and if so, what kind.

Forgetting her Mom died is a sign of Dementia.

This is not just usual getting old behavior.

I recommend getting her in for a complete physical.

Have you had your Mom diagnosed? She is only 78 (everything is relative; it is my age!), but asking to call or go see your mother is NOT "getting old stuff". Getting old stuff is forgetting everyone's name, forgetting to turn the gas off or be certain that the fridge door is closed. Forgetting whether you put your favorite TV show on record, or whether you paid the phone bill. It is not, definitely, believing your long dead mother is alive. That is getting more into the dementia area. If you do not now have DPOA made out to whomever she would like to act for her financially or health wise in future this is the time to do that, before anything progresses. Age wise it is the time to do it in any case. When you are POA for health you can pass this by her doctor and request an assessment.
Meanwhile, yes, if your assessment that Mom is fine with just a few old age issues, then speak with her. Next time she does this ask her frankly and outright if she doesn't realize her mother passed away. Ask her if she remembers when and how her mother died. Then ask her if she will play some games with you, because you worry her memory is slipping quite badly. Do the word memory test where you ask her to remember three words. Then talk about 15 minutes on another subject and ask her for those three words again. Ask her to draw you a clock that is set for some time you give her, say 2:15. You can look up some simple tests online if you like. It is time to be frank. I would want my daughter to come to me and say "Mom, you told me you wanted to go to see your Mom the other day. Do you honestly forget sometmes that your Mom is gone now, and how and when she died". Often elders realize they are failing, and in early stages are willing to talk about it. My brother was glad he knew of his early Lewy's dementia diagnosis and he actually became happy to describe to me how his "failing mind" interpreted the world differently.

Therapeutic fibs are totally acceptable, or just humoring her. Yesterday my MIL called me from her LTC and told me she was moving home and needed our help. Her home was her childhood home in Chicago on Rasher Ave. and she is currently in MN. So I went through a series of questions with her and she came to a slow, gentle realization. At the end of the conversation I reminded her that she needs to be able to get out of bed by herself (which she can't do) and that once her doc gives her the green light to be able to live by herself, then she can leave and that her job is to keep working on this. She was mostly satisfied with this answer, as some confusion will always linger. The call ended on a positive note. She calls us many times and we have an almost identical conversation. That's the best we can do. May you have peace in your heart as you journey down this path with your mother.

No, do not correct or explain.

My mom did the same thing. I made the mistake of trying to explain a couple of times. Each time was as if mom had heard of their passing for the first time. Even anger from mom that she hadn't been told.

Therapeutic white lies are much better. She is on vacation, we will call when she returns, etc.