Suppose the policy reaction function for the RBA is given by r=¯r+gπr=r¯+gπ

Economics Dec 27, 2020

Suppose the policy reaction function for the RBA is given by r=¯r+gπr=r¯+gπ. If the RBA increased the value of the parameter gg, which of the following would occur?

A. The slope of the AS curve would become flatter (i.e. closer to horizontal).

B. The slope of the AD curve would become flatter (i.e. closer to horizontal).

C. The AS curve would shift inwards (to the left).

D. The AD curve would shift inwards (to the left).

E. Both A and C.

Expert Solution

The answer is A).

When the parameter gg increases, a given change in inflation leads to a higher percentage change in nominal interest rate, i.e., the monetary authority is more responsive to changes in inflation. In this case, real interest rate is less sensitive to changing inflation, and thus investments do not vary with prices. Hence, the aggregate demand curve is flatter.

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