Starting from long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, a permanent reduction in the central bank's inflation target causes the nominal interest rate to:
A) decline continuously until reaching a lower level in the long run.
B) increase initially and then decline until reaching a lower level in the long run.
C) decline immediately to a lower level in the long run.
D) fall below and then rise continuously to long-run level below the initial level.

Question

Quizplus · Accepted Answer

A permanent reduction in the central bank's inflation target would initially lead to higher real interest rates as the nominal interest rate does not adjust immediately. This would reduce aggregate demand, leading to lower output and inflation. Over time, as expectations adjust to the new lower inflation target, the nominal interest rate would decline, settling at a lower level in the long run. This process describes an initial increase followed by a decline in nominal interest rates.

Starting from Long-Run Equilibrium in the Dynamic Model of Aggregate