Final answer:
The inflation rate in response to a negative real shock, addressed by the Federal Reserve through a focus on inflation, could increase or decrease. A severe real shock like a drought usually leads to higher inflation, but contractionary monetary policy could reduce inflation at the expense of worsening a recession. The Fed's options are often constrained by fiscal policy and require innovative approaches to manage the economy.
Step-by-step explanation:
If the Federal Reserve decides to address a negative real shock by focusing on inflation instead of recession, the likely outcome is that the inflation rate in the economy could either increase or decrease, depending on the nature of the shock and the policy response. Typically, a negative real shock, like a severe drought, would decrease supply, potentially leading to higher prices for the affected goods, thereby increasing inflation if demand remains constant. However, if the Federal Reserve prioritizes controlling inflation through contractionary monetary policy, such as raising interest rates, it may counter the inflationary pressure but at the risk of deepening the recession by curbing demand.
During the Great Recession, the Federal Reserve's options were limited due to high public debt and budget deficits, prompting them to devise new strategies to stimulate the economy. A similar approach to change the rules of the game was taken during the 2020 economic downturn, where aggressive fiscal policy complemented the monetary policy actions. The essence of the Federal Reserve's monetary policy tools, including managing interest rates and controlling money supply, aimed at stimulating economic growth or containing inflation, depending on the prevailing economic conditions.