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In March 2018, the Federal Reserve Bank officials met and decided to increase the interest slightly...

In March 2018, the Federal Reserve Bank officials met and decided to increase the interest slightly (a quarter of one percent) and have hinted that there will be two or more interest hikes in 2018. The reason for these hikes is to prevent the economy from overheating as unemployment continues to drop. Using AD-AS model, show what could happen to the economy if the Fed hiked interest rate when the economy is close to full employment.

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Overheating of the economy takes place , when productive capacities of the economy is not able to match the growing aggregate demand. (AS>AD) , As a result interest rate is hiked so as to prevent growing demand for money . Inflation will fall , unemployment rate will rise.
If economy is close to full employment , AS is close to being vertical. An increase in interest rate , would lower the demand for money and aggregate demand curve would shift to left , along the AS curve. Inflation will fall.

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