Based on the figure below, 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 $\pi$' and the Federal Reserve's target inflation rate is $\pi$*1. If the Federal Reserve lowers its target inflation rate to $\pi$*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

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 Figure Below, the Economy Is Initially at Point