According to the Taylor rule, the Fed should raise the federal funds interest rate when inflation ________ the Fed's inflatio
n target or when real GDP ________ the Fed's output target. A. rises above; rises above B. rises above; drops below C. drops below; rises above D. drops below; drops below
The interest rate hike is a tight monetary policy that serves as an instrument for the Fed to manipulate the economic environment in times of inflation and economic overheating. This is because when interest rates rise, people stop consuming and investing to invest money in government bonds as the expectation of earning a good income. Thus less money circulates in the economy, lowering inflation (which is a monetary phenomenon) and slowing down economic activity. Economic activity needs to be contained only in situations such as the one in which real GDP is above the production target, which represents unsustainable production.
Plus: When inflation is low and the economy is stagnant, the Fed can lower interest rates to stimulate the economy. That is, the interest rate is a powerful tool the Fed has to keep the economic environment healthy.
