Based on the figure below, the economy is initially at point A on the monetary policy reaction function (RF₁) and the aggregate demand curve (AD₁). The actual rate of inflation is$\pi$' and the Federal Reserve's target inflation rate is $\pi$*₁. If the Federal Reserve raises its target inflation rate to $\pi$*₃, then the Federal Reserve's monetary policy reaction function will _____ and the aggregate demand curve will _____. A) shift to RF₃; shift to AD₂ B) shift to RF₂; shift to AD₂ C) shift to RF₃: shift to AD₃ D) shift to RF₂: shift to AD₃

Question

Quizplus · Accepted Answer

A higher target inflation rate means easier monetary policy, which is seen as a downward shift in the Fed's policy reaction. At RF₃ the Fed is setting the real interest rate lower than before at each given rate of inflation. Aggregate expenditure and the short-run equilibrium output are increased at each rate of inflation as seen in the shift in AD curve from AD₁ to AD₂.

Based on the Figure Below, the Economy Is Initially at Point