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In order to study the interactions between the goods and money markets, the monetary policy (MP) curve has been developed to represent the money market
In order to study the interactions between the goods and money markets, the monetary policy (MP) curve has been developed to represent the money market. This curve was developed in the context of countries adopting inflation targeting as the basis of monetary policy. The MP curve is based on the assumption that the central bank will:
A. lower interest rates when inflation rises above the target
B. raise interest rates when inflation rises above the target
Expert Solution
The monetary policy rule is given as
In this case, as inflation 
increases over target rate 
??????, the policy rule suggests that the central bank should increase the nominal interest rate. Higher inflation increases output above it's natural level. To dampen the effect the central bank must increase the interest rate to curb investment and consumption to direct the output toward natural level.
Given the options :
- Lower interest rate will increase output and inflation further above target.
- Higher interest rate will decrease investment and consumption. This will decrease output and inflation back to it's target rate.
Therefore, the correct option is : B
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