Chartered Financial Analyst (CFA) Practice Exam Level 2 - 2025 Free CFA Level 2 Practice Questions and Study Guide

The Taylor Rule is a formula used to guide central banks in setting interest rates based on economic conditions, specifically focusing on inflation and output. In its standard form, the Taylor Rule can be expressed as:

R = Rn + π + 0.5(π - π*) + 0.5(y - y*)

In this equation:

- R represents the nominal interest rate.

- Rn is the equilibrium real interest rate.

- π refers to the current rate of inflation.

- π* is the target rate of inflation.

- y reflects real GDP, while y* represents potential GDP.

The key components are the adjustments based on the deviation of actual inflation from target inflation (π - π*) and the deviation of actual output from potential output (y - y*). The use of the coefficients (0.5) emphasizes the responsiveness of the interest rate to both inflation and output gaps.

The correct formulation (the provided answer) captures these essential elements accurately: it includes a positive adjustment for the gap between actual and target inflation while also incorporating the output gap correctly.

Understanding this rule is crucial for gauging how central banks might respond to changing economic conditions, thus influencing interest rates pragmatically based on deviations from desired economic performance. The coefficients reflect