Question

Suppose two countries are identical except for the fact that the central bank of one country lets interest rates rise sharply when real GDP rises above potential GDP and the other does not. Draw the aggregate demand curve for each country. What are the benefits and drawbacks of each country’s policy?

Answer 1

the bold line is rule 1 and the dotted line represents the rule 2

shifting of the policy rule from 1 to 2, will imply a higher real interest rate which would lead to a fall in investment expenditure hence aggregate demand would fall hence AD shifts to the left this in the long run would push the price level down. In the short run real gdp will fall and the reason for fed to change its policy could be put down to controlling inflation or bringing down the level of inflation