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When federal funds rates are changed (increased), what is the consequent effect on employment and inflation?

1. employment decreases along with increase in inflation
2. employment decreases along with decrease in inflation
3. employment increases along with decrease in inflation
4. both (a) and (b)

Correct answer: employment decreases along with decrease in inflation

Solution

When the Federal Reserve raises the federal funds rate: (1) Borrowing becomes more expensive → reduced consumer spending and business investment. (2) Economic activity slows → unemployment rises (employment decreases). (3) Reduced demand reduces price pressure → inflation decreases. This is classic contractionary monetary policy: employment and inflation both fall.

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