Question

If the Federal Reserve announces that its target for the federal funds rate is rising from 4 percent to 4.25 percent, how do you expect workers and firms to react?
a.) As long as the Fed's announcement is credible, workers and firms will increase their consumption and investment spending, which will increase aggregate demand and inflation.
b.) As long as the Fed's announcement is credible, workers and firms will reduce their consumption and investment spending, which will reduce aggregate demand and reduce inflation.
c.) If the Fed's announcement is not credible, workers and firms will not expect inflation to fall so they will reduce their consumption and investment spending, which will increase aggregate demand and reduce inflation.
d.) Workers and firms will incorporate the increase in interest rates into their expectations of inflation, and they will expect inflation to rise as a result of Fed's policy announcement.

Answer 1

Answer:

B) As long as the Fed's announcement is credible, workers and firms will reduce their consumption and investment spending, which will reduce aggregate demand and reduce inflation.

Explanation:

If the FED announces that it will increase the federal funds rate, it will increase the interest that banks charge other banks for lending them money in order to  comply with the reserve ratio. This increase would make banks hand out less loans and be more careful in order to reduce their need for overnight funds.

If banks reduce their loans, their capacity for creating money will also be reduced, lowering the consumption level and investment spending of both workers (households) and private firms.