Final answer:
The Federal Reserve should set the real interest rate at a level that equates planned aggregate expenditure with potential output, closing any recessionary or inflationary gaps to maintain equilibrium GDP at the full employment level as shown in the Keynesian Cross Diagram.
Step-by-step explanation:
The Federal Reserve should set the real interest rate at a level where planned aggregate expenditure equals the potential output, resulting in the elimination of any output gap. To achieve full employment or potential GDP equilibrium, any existing recessionary or inflationary gap must be addressed through fiscal and monetary policy adjustments.
For a recessionary gap, where actual GDP is below potential GDP, expansionary policies such as tax cuts or increased government spending can shift the aggregate expenditure schedule upward, leading to an increase in real GDP to meet potential output. Conversely, to close an inflationary gap where actual GDP is above potential GDP, contractionary policies like tax increases or reduced government spending can shift the aggregate expenditure schedule downward, lowering real GDP to the potential output level.
The Keynesian Cross Diagram illustrates equilibrium at point E, where national income and aggregate expenditure are equal. To maintain this equilibrium at full employment, the Fed may adjust interest rates influencing investment (I), which is one component of aggregate expenditure.