Money and the Federal Reserve Practice Exam

The Taylor rule is a simple guideline for setting the central bank’s policy rate based on how far inflation is from its target and how far the economy is from its potential (the output gap). It expresses the target nominal rate as a function of current inflation and the gaps: you adjust the policy rate upward when inflation is above target or the economy is running hot, and you cut it when inflation is below target or the economy is weak. A common form is i = r* + pi + 0.5(pi − pi*) + 0.5(y − y*), where i is the policy rate, pi is inflation, pi* is the target inflation, y is actual output, y* is potential output, and r* is the neutral real rate. The equal weights on the inflation gap and the output gap reflect a balance between stabilizing prices and stabilizing real activity. Remember, it’s a useful rule-of-thumb, not a strict prescription, and policymakers may deviate for other considerations like financial stability.