Question

The economy begins at potential GDP with an inflation rate of 2 percent. Suppose a price shock pushes inflation up to 6 percent in the short run, but the Fed views the effect on inflation as temporary. It expects the inflation adjustment line to shift back down to 2 percent the next year, and in fact, the inflation adjustment line does shift back down. Now suppose that because the Fed is sure that this inflationary shock is only temporary, it decides not to follow its typical policy rule but instead maintains the interest rate at its previous level. What happens to real GDP? Real GDP will adjust to be above potential GDP. Real GDP will adjust to be equal to potential GDP. Real GDP will adjust to be below potential GDP. Real GDP will not change.

          The economy begins at potential GDP with an inflation rate of 2 percent. Suppose a price shock pushes inflation up to 6 percent in the short run, but the Fed views the effect on inflation as temporary. It expects the inflation adjustment line to shift back down to 2 percent the next year, and in fact, the inflation adjustment line does shift back down.
Now suppose that because the Fed is sure that this inflationary shock is only temporary, it decides not to follow its typical policy rule but instead maintains the interest rate at its previous level. What happens to real GDP? 
Real GDP will adjust to be above potential GDP. 
Real GDP will adjust to be equal to potential GDP. 
Real GDP will adjust to be below potential GDP. 
Real GDP will not change.

Added by Cassandra S.

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