Based on the given figure, the economy is initially at point A on the monetary policy reaction function (RF₁)and the aggregate demand curve (AD₁). The actual rate of inflation is π' and the Federal Reserve's target inflation rate is π*₁.
If the Federal Reserve lowers its target inflation rate to π*₂, then the Federal Reserve's monetary policy reaction function will ________ and the aggregate demand curve will ________.
A)shift to RF₃; shift to AD₂
B)shift to RF₂; shift to AD₂
C)shift to RF₃; shift to AD₃
D)shift to RF₂; shift to AD₃

Question

Based on the given figure, the economy is initially at point A on the monetary policy reaction function (RF₁)and the aggregate demand curve (AD₁). The actual rate of inflation is π' and the Federal Reserve's target inflation rate is π*₁.   
If the Federal Reserve lowers its target inflation rate to π*₂, then the Federal Reserve's monetary policy reaction function will ________ and the aggregate demand curve will ________.
A)shift to RF₃; shift to AD₂ 
B)shift to RF₂; shift to AD₂ 
C)shift to RF₃; shift to AD₃ 
D)shift to RF₂; shift to AD₃

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. At RF₂ the Fed is setting the real interest rate higher than before at each given rate of inflation. Aggregate expenditure and the short-run equilibrium output are reduced at each rate of inflation as seen in the shift in AD curve from AD₁ to AD₃.

Based on the Given Figure, the Economy Is Initially at Point