We have seen that short-run equilibrium output falls when the Fed raises the real interest rate. Suppose the relationship between short-run equilibrium output Y and the real interest rate r set by the Fed is given by Y 5 1,000 2 1,000r.

Suppose also that the Fed’s reaction function is the one shown in the following table. For whole-number inflation rates between 0 and 4 percent, find the real interest rate set by the Fed and the resulting short-run equilibrium output. Graph the aggregate demand curve numerically. (LO1)

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Rate of inflation, T Real interest rate, r 0.0 0.02 0.01 0.03 0.02 0.04 0.03 0.05 0.04 0.06