If prices are sticky and there are no aggregate demand shocks, and if the Fed raises the interest rate, ________ and ________.
A) unemployment falls; potential output falls
B) the real interest rate falls; short-run output falls
C) the unemployment rate rises; short-run output rises
D) the real interest rate rises; short-run output falls
E) the real interest rate falls; current output falls

Question

Quizplus · Accepted Answer

If prices are sticky and there are no aggregate demand shocks, then a rise in interest rate will lead to a decrease in investment and consumption, which will lead to a decrease in aggregate demand. Since prices are sticky, output will not adjust immediately, causing a decrease in short-run output. At the same time, since interest rates have gone up, the real interest rate will also rise.

If Prices Are Sticky and There Are No Aggregate Demand