If monetary policymakers do not want the current inflation rate to increase, yet they observe increasing aggregate demand from higher government purchases, will they have to accept a higher inflation target? Explain.

What will be an ideal response?


Not necessarily. If the increase in aggregate demand puts upward pressure on inflation, the monetary policymakers could compensate by shifting their monetary policy reaction function to the left, increasing the real interest rate at every rate of inflation. In this case the higher real interest rate should cause the dynamic aggregate demand curve to shift left restoring long-run equilibrium at the target rate of inflation.

Economics

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Economics