Question

Suppose the Fed is considering two different policy rules, shown in the following table. Graph the policy rules.

Inflation(0 2 4 6 8 ) Policy Rule 1 Interest Rate (1 3 5 7 9)Policy Rule 2 Interest Rate (3 5 7 9 11)

If the Fed currently is following Policy Rule 1 and then shifts to Policy Rule 2, which way will the aggregate demand curve shift? What reasons might the Fed have for changing its policy?

Answer 1

inflation	Policy Rule _IR1	Policy Rule _IR2
0	1	3
2	3	5
4	5	7
6	7	9
8	9	11

A shift from Policy rule 1 to policy rule 2 will shift the Aggregate demand curve to the left. This is because of the potential fall in the private investment component of the AD function. The investment by the private sector priced at the interest rate will be more costly now due to the shift from policy rule 1 to policy rule 2. The interest payments also the interest foregone on the invested capital will now be greater than before. Hence the private investment demand will fall shifting the aggregate demand curve to the left.

The reason why the Fed may want to change its policy from Policy rule 1 to Policy rule 2 might be because the growth in the economy is hyper inflating. That is the growth in the economy is have a tendency to increase the general price level which tend to impact the general welfare , living standard adversely.

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