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FRM Part II · FRM Exam Part II · Monetary and Fiscal Policy: Safeguarding Stability and Trust

A central bank follows a Taylor-type rule: policy rate = neutral real rate + inflation + 0.5 x (inflation - target) + 0.5 x output gap. Neutral real rate is 1.0%, target is 2.0%, inflation is 5.0%, and the output gap is -2.0%. What policy rate does the rule prescribe?

The rule prescribes 6.5%. Add the neutral real rate of 1.0% and inflation of 5.0%, then 1.5% for the inflation gap (0.5 x 3.0) and subtract 1.0% for the negative output gap (0.5 x -2.0), giving 6.5%.

  1. A6.5%Correct
  2. B7.5%
  3. C6.0%
  4. D5.5%

Explanation

Rate = 1.0 + 5.0 + 0.5 x (5.0 - 2.0) + 0.5 x (-2.0) = 1.0 + 5.0 + 1.5 - 1.0 = 6.5%. Ignoring the negative output gap gives 7.5%, and omitting the inflation gap term gives 5.0% plus adjustments incorrectly.

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