Inflation Expectations Weaken Monetary Tightening

Steps:

• Raising interest rates increases borrowing costs, discouraging consumer spending and investment.
• This reduces aggregate demand, easing inflationary pressures by slowing price increases.
• If consumers expect faster future inflation, they accelerate current spending to beat rising prices.
• Result: Higher demand offsets the policy's contractionary effect, prolonging inflation.

Why B is correct:

• In macroeconomic theory, rising inflation expectations lead to adaptive behaviors where agents spend more now, reducing the real interest rate's impact on demand (per the expectations-augmented Phillips curve).

Why the others are wrong:

• A: Faster aggregate supply growth relative to demand is deflationary, enhancing the policy's effectiveness in curbing inflation.
• C: Credit-based spending makes consumers more sensitive to rate hikes, amplifying the policy's demand-reducing power.
• D: Higher foreign rates could prompt capital inflows if domestic rates rise, strengthening the currency and further dampening imported inflation.

Final answer: B