Final answer:
The Fed should adjust the real interest rate to steer the economy towards potential GDP, decreasing rates to close a recessionary gap and increasing rates to correct an inflationary gap, following a monetary policy that does not rely on fiscal policy changes.
Step-by-step explanation:
To eliminate any output gap, the Fed should set the real interest rate at a level where planned aggregate expenditure equals potential output. If there is a recessionary gap, where current output is below potential GDP, then the Fed may opt to decrease the real interest rate to stimulate the economy and shift the aggregate expenditure up, leading to a new equilibrium at potential GDP. Conversely, if there is an inflationary gap, where current output exceeds potential GDP, the Fed may need to increase the real interest rate to reduce aggregate expenditure, therefore bringing the economy back to potential GDP. This decision should align with Keynesian policies, with the exact adjustments depending on the current state of the economy and how significantly fiscal policy is affecting aggregate demand. While fiscal policy decisions such as government spending and taxing indeed influence the economy, when it comes specifically to the Fed's target for the real interest rate, it should base its strategy on monetary policy without depending on fiscal policy.