Beginning at long-run equilibrium in the dynamic model of aggregate demand and aggregate supply, if the central bank permanently reduces its inflation target, then in the initial period of the change output _____ and inflation _____.
A) increases; increases
B) increases; decreases
C) decreases; decreases
D) decreases; increases

Question

Quizplus · Accepted Answer

In the initial period following a permanent reduction in the inflation target by the central bank, output decreases because higher real interest rates reduce investment and consumption. Inflation decreases as the central bank tightens monetary policy to achieve the lower inflation target.

Beginning at Long-Run Equilibrium in the Dynamic Model of Aggregate