Question

The Fed sets higher interest rate at each price level. Will Inflation and Real GDP increase or decrease?

Provide Diagram.

Answer 1

When Fed sets higher interest rate at each pric level, it will lead to increase in cost of borrowing in the economy which will lead to a decrease in investment and consumption spending. Also, higher interest rate will increase net capital outflow leading to domestic currency's appreciation. This appreciation will increase the price of exports but decrease the price of imports, thus, decreasing exports and increasing imports which will cause the net exports of the country to fall. Thus, a decrease in investment, consumption and net exports leads to a decrease in aggregate demand for goods and services in the economy, shiting the aggregate demand curve leftwards from AD to AD'. This, at given level of aggregate supply, will cause surplus of the goods and services leading to a decrease in price level from P to P' and decrease in real GDP from Y to Y'

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