Suppose that the Federal Reserve has a 2% target on inflation. If actual inflation is 1%, then the Fed will want the new real interest rate to be:
A)higher than the neutral interest rate.
B)lower than the neutral interest rate.
C)equal to the inflation rate.
D)equal to the neutral interest rate.

Question

Quizplus · Accepted Answer

The real interest rate is the nominal interest rate minus the inflation rate. If the Fed has a 2% target on inflation but the actual inflation is only 1%, then the real interest rate is actually higher than the Fed intended. In order to lower the real interest rate to the target level, the nominal interest rate must be lowered. Therefore, the new real interest rate must be lower than the current level, which means it must be lower than the neutral interest rate. Choice B is the only option that satisfies this condition.

Suppose That the Federal Reserve Has a 2% Target on Inflation