The aggregate demand curve shifts to the left when the Fed:
A)increases its target inflation rate, reflected by a downward shift in the Fed's policy reaction function.
B)decreases its target inflation rate, reflected by an upward shift in the Fed's policy reaction function.
C)increases real interest rates in response to inflation, but does not change its target inflation rate or the Fed's policy reaction function.
D)decreases real interest rates in response to inflation, but does not change its target inflation rate or the Fed's policy reaction function.

Question

Quizplus · Accepted Answer

An upward shift in the Fed's policy reaction function means that the Fed is setting the real interest rate higher than before at each given rate of inflation. So each level of inflation now corresponds to a new lower level of output. Thus an upward shift of the Fed's policy reaction function makes the AD curve shift to the left.

The Aggregate Demand Curve Shifts to the Left When the Fed