The aggregate demand curve is downward sloping because a higher inflation rate leads the central bank to raise ________ interest rates, thereby ________ equilibrium output.

Question

BlackTom AI · Accepted Answer

Higher inflation causes the central bank to raise the real interest rate, which reduces aggregate demand and thus lowers equilibrium output. 1) Relevant knowledge points and concepts - Real interest rate r = nominal interest rate i − expected inflation π^e. The real rate is the cost of borrowing in terms of real goods and services and is what affects consumption, investment, and net exports. - Aggregate demand (AD) depends negatively on the real interest rate because higher r reduces investment and interest-sensitive consumption and tends to appreciate the exchange rate, reducing net exports. - The central bank typically responds to higher inflation by tightening monetary policy (raising policy interest rates), which raises the real cost of borrowing. 2) Step-by-step reasoning - Start with the identity r = i − π^e. If inflation rises and the central bank tightens policy, it raises the policy nominal rate i by enough that the resulting real rate r increases (dr/dπ > 0 under a standard tightening response). - AD can be written as Y = C(Y − T, r) + I(r) + G + NX(r). The partial derivative ∂Y/∂r < 0 because consumption and investment fall when r rises. - Chain rule: dY/dπ = (∂Y/∂r)·(dr/dπ). Since ∂Y/∂r < 0 and dr/dπ > 0, dY/dπ < 0. Thus higher inflation leads to lower equilibrium output, producing a downward-sloping AD curve. 3) Calculation/expressions shown - r = i − π^e - Y = C(·, r) + I(r) + G + NX(r) - dY/dπ = (∂Y/∂r)(dr/dπ) with ∂Y/∂r < 0 and dr/dπ > 0 ⇒ dY/dπ < 0 4) Why the correct answer is correct - The choice "real; lowering" captures that the policy change that matters for spending is the real interest rate, and raising it reduces equilibrium output, so AD slopes downward. 5) Why the other options are incorrect - b (nominal; raising): Raising nominal rates in response to inflation is true, but an increase in nominal rates does not raise equilibrium output; it lowers demand. Also the key policy variable affecting AD is the real rate. - c (real; raising): Raising the real rate lowers, not raises, equilibrium output. - d (nominal; lowering): The central bank would not lower nominal rates in response to higher inflation; lowering would increase demand, contradicting the downward slope. Conclusion: The correct choice is a. real; lowering, which matches the provided answer.

The aggregate demand curve is downward sloping because a higher inflation rate leads the central bank to raise interest rates, thereby equilibrium output.Single choice

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The aggregate demand curve is downward sloping because a higher inflation rate leads the central bank to raise ________ interest rates, thereby ________ equilibrium output.Single choice

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