CFA Level IEconomicsMedium
A central bank uses the Taylor Rule to guide policy. The neutral real interest rate is 2%, current inflation is 3%, the inflation target is 2%, and the output gap is +1%. Using equal weights of 0.5 on both gaps, what target policy rate does the Taylor Rule suggest?
- A4.5%
- B6.0%
- C5.5%
- D6.5%
Show answer & explanationAnswer & explanation
Correct answer: B. 6.0%
Taylor Rule: i = r* + π + 0.5(π - π*) + 0.5(output gap) = 2% + 3% + 0.5(1%) + 0.5(1%) = 2 + 3 + 0.5 + 0.5 = 6.0%.
Why the other options are wrong
- A. Omits one of the gap adjustments.
- C. Uses only one 0.5 weight adjustment instead of both.
- D. Overstates the rate by double-counting an adjustment.
Taylor Rule
A monetary policy guideline that recommends a central bank's target interest rate based on deviations of inflation and output from their targets.
- Formula: i = r* + π + 0.5(π-π*) + 0.5(output gap)
- r* is the neutral real interest rate
- Positive output gap or inflation gap raises the recommended rate
Memory trick: Neutral rate plus inflation plus half of each gap — Taylor's simple recipe.