To follow a monetary policy rule, the central bank raises the nominal interest rate by:
A) raising the inflation target.
B) decreasing the money supply.
C) increasing the GDP gap.
D) decreasing inflation expectations.

Question

Quizplus · Accepted Answer

According to the Taylor Rule, the central bank should adjust the nominal interest rate in response to deviations of inflation from its target and deviations of output from potential. To reduce inflation, the central bank should raise the nominal interest rate by decreasing the money supply. Option A is incorrect because raising the inflation target would lead to higher inflation, which is contrary to the goal of reducing inflation. Option C is incorrect because increasing the GDP gap (the difference between actual and potential GDP) would indicate an overheated economy and the need to raise interest rates to cool it down, but the question asks about reducing inflation. Option D is incorrect because decreasing inflation expectations could make it more difficult for the central bank to achieve its inflation target, but it would not directly lead to a change in the nominal interest rate.

To Follow a Monetary Policy Rule, the Central Bank Raises