Chartered Financial Analyst (CFA) Practice Exam Level 2

Which component influences the Federal Reserve's target for the federal funds rate according to the Taylor Rule?

1. The unemployment rate

2. The consumer price index

3. The inflation gap

4. The savings rate

The correct answer is: The inflation gap

The Taylor Rule suggests that the Federal Reserve adjusts the federal funds rate based on both inflation and economic output relative to their target levels. The component that specifically influences the target for the federal funds rate in this context is the inflation gap, which measures the difference between actual inflation and the target inflation rate set by the Fed. When actual inflation rises above the target, the Taylor Rule would recommend an increase in the federal funds rate to help stabilize prices. Likewise, if inflation is below the target, a lower rate may be suggested to stimulate economic activity. This approach directly links the monetary policy stance to inflation dynamics, enabling policymakers to respond effectively to fluctuations in price levels in the economy. While the unemployment rate plays a significant role in the overall economic assessment and may indirectly inform monetary policy, it does not have a direct contribution to the formula defined by the Taylor Rule. The consumer price index serves as an indicator of inflation but is not the direct measure used in the context of the Taylor Rule. Additionally, the savings rate is not a component of the Taylor Rule, indicating that it does not directly impact the target federal funds rate. Thus, the inflation gap is central to how the Taylor Rule shapes the Fed's policy decisions regarding interest rates.