Suppose we know the following information about a hypothetical economy: -real GDP = $485 billion
-potential GDP = $500 billion
-inflation rate = 4%
-target overnight interest rate = 6%
If the central bank implements a contractionary monetary policy in an effort to reduce the inflation rate,the short-run effect of this policy is likely to be that

Question

Quizplus · Accepted Answer

DA contractionary monetary policy typically involves increasing interest rates to reduce inflation. This makes borrowing more expensive, which can reduce spending and investment, leading to lower economic activity. In the short run, this can increase unemployment as businesses adjust to the decreased demand. Therefore, unemployment may rise further beyond the Non-Accelerating Inflation Rate of Unemployment (NAIRU). Additionally, while the policy aims to reduce inflation, the immediate effect is an increase in interest rates, but over time, it is expected to lower inflation. However, the immediate effect of raising interest rates does not directly lower inflation; it's a mechanism intended to cool down the economy and reduce inflationary pressures over time. Thus, the correct understanding involves recognizing the rise in unemployment due to reduced economic activity and the nuanced impact on interest rates and inflation.

Suppose We Know the Following Information About a Hypothetical Economy