If the central bank is facing the zero bound constraint and announces a higher inflation target,
A) the real interest rate will increase, which will decrease aggregate expenditure.
B) the real interest rate will decrease, which will increase aggregate expenditure.
C) the nominal interest rate will increase, which will decrease aggregate expenditure.
D) the nominal interest rate will decrease, which will increase aggregate expenditure.

Question

Quizplus · Accepted Answer

When a central bank is facing the zero bound constraint, it means that the nominal interest rate cannot be lowered any further. To stimulate the economy, the central bank may announce a higher inflation target to decrease the real interest rate (nominal interest rate minus inflation rate), which will increase aggregate expenditure. Therefore, choice B is correct. Choices A, C, and D are incorrect because they go against the logic of how changes in interest rates affect aggregate expenditure.

If the Central Bank Is Facing the Zero Bound Constraint