Imagine the UK in the period before the Great Recession of 2009. Suppose the economy experiences a negative demand shock, but one much smaller than the one leading up to the Great Recession. What should the Bank of England do in order to respond in an optimal way? Compare with the response if instead the Bank of England were to adjust the interest rate to deviations of inflation from target according to an ad-hoc fixed rule.

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The Bank of England should lower ... View the full answer