According to the Taylor rule, the Fed reacts to an increase in inflation by ____

Question

According to the Taylor rule, the Fed reacts to an increase in inflation by ____________. __________ thus stabilizing inflation.

A. increasing the Fed Funds rate one-for-one; The resulting increase in real rates reduces aggregate demand.

B. increasing the Fed Funds rate more than proportionally; The resulting increase in real rates reduces aggregate demand

C. increasing the Fed Funds rate less than proportionally; The resulting fall in real rates increases aggregate demand.

D. lowering the Fed Funds rate; The resulting increase in real rates reduces aggregate demand

Explanation / Answer

B. increasing the Fed Funds rate more than proportionally; The resulting increase in real rates reduces aggregate demand

Explanation: According to the Taylor rule, for each one-percent increase in inflation, the Fed needs to increase the nominal interest rate by more than one percentage point. This will result in an increase in the real interest rate, which will reduce the aggregate demand.

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