CFA Level I · CFA Level I Exam · Monetary Policy
Trend real growth is 1.5% and the inflation target is 2.5%. The central bank holds its policy rate at 4.0%, but inflation is forecast to fall to 1.0% and growth is weakening. Which action is the central bank most likely to take to keep its stance consistent with its mandate?
The central bank would most likely lower the policy rate below 4.0%. The neutral rate is 4.0%, so policy is currently neutral, but forecast inflation below target and weakening growth call for an expansionary stance to lift demand and inflation.
- ARaise the policy rate above 4.0% to anchor inflation expectations
- BKeep the policy rate at 4.0% because it equals the neutral rate
- CLower the policy rate below 4.0% to move the stance toward expansionaryCorrect
Explanation
Neutral rate = 1.5% + 2.5% = 4.0%, so the current stance is neutral. With inflation forecast below target and growth weakening, the bank would likely ease, moving the rate below neutral. Raising or holding would not address the shortfall in inflation.
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