Question

If the Fed believes the inflation rate is about to increase, it should

A. Use a Contractionary fiscal policy to increase the interest rate and shift AD to left
B. Use an expansionary monetary policy to lower the interest rate and shift AD to the right
C. Use a contractionary monetary policy to increase the interest rate and shift AD to the left

Answer 1

Option (C) is correct.

Step-by-step explanation:

Monetary policy is used by the Fed to control the inflation rate or money supply in an economy and maintain the price stability.

In this case, if it believes that inflation rate is about to increase in the near future then it uses the contractionary monetary policy by increasing the interest rate in an economy which reduces the money supply in an economy. Hence, this will results in more bank reserves and also reduces the investment component of aggregate demand equation which shifts the aggregate demand curve leftwards.

AD = Consumption + Investment + Government spending + Net exports