When the Federal Reserve reduces its target rate of inflation, it will set a ________ real interest rate at every inflation rate and the aggregate demand curve will ________.
A)higher; shift to the right
B)lower; shift to the right
C)higher; shift to the left
D)lower; shift to the left

Question

Quizplus · Accepted Answer

A lower target inflation rate means tighter monetary policy, which is seen as an upward shift in the Fed's policy reaction. With the Fed setting the real interest rate higher than before at each given rate of inflation, aggregate expenditure and the short-run equilibrium output is reduced at each rate of inflation. Alternatively, we can say that each level of inflation now corresponds to a new lower level of output. Thus an upward shift of the Fed's policy reaction function shifts the AD curve to the left.

When the Federal Reserve Reduces Its Target Rate of Inflation