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

Using a Taylor-type rule, i = r* + pi + 0.5(pi - pi*) + 0.5(y gap), a central bank has a neutral real rate r* of 1.5%, an inflation target pi* of 2.0%, and observes inflation of 4.0% and an output gap of -2.0%. The current policy rate is 4.5%. What does the rule imply for the policy rate, and how does it compare with the current rate?

The rule implies a policy rate of 5.5%, so the current 4.5% rate is 1.0 percentage point too low. The calculation is 1.5 + 4.0 + 0.5 x (4.0 - 2.0) + 0.5 x (-2.0) = 5.5%, with the negative output gap offsetting the inflation gap.

  1. A5.5%, so the current rate is 1.0 percentage point too lowCorrect
  2. B4.5%, so the current rate is appropriate
  3. C3.5%, so the current rate is 1.0 percentage point too high
  4. D6.5%, so the current rate is 2.0 percentage points too low

Explanation

i = 1.5 + 4.0 + 0.5(4.0 - 2.0) + 0.5(-2.0) = 1.5 + 4.0 + 1.0 - 1.0 = 5.5%. The current rate of 4.5% is 1.0 point below it. The 6.5% option ignores the negative output gap, and 3.5% mistakenly omits the inflation term pi from the sum while including the other terms.

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