Final answer:
The correct answer is 'a. exports decrease and imports increase' when the Federal Reserve raises the federal funds rate. This is attributed to a stronger dollar, which makes U.S. exports more expensive and imports cheaper, reducing exports and increasing imports.
Step-by-step explanation:
If the Federal Reserve raises the federal funds rate, the correct answer to the question is that exports decrease and imports increase. This is because an increase in the federal funds rate leads to higher domestic interest rates, which in turn attracts foreign capital seeking higher returns. As a result, the demand for dollars increases, driving up the value of the dollar. This makes U.S. exports more expensive for foreign buyers, reducing export levels. Simultaneously, the stronger dollar makes foreign goods cheaper for U.S. consumers, which increases imports.
Therefore, the answer is 'a. exports decrease and imports increase'. The higher interest rates also reduce investment, because costlier borrowing can dissuade companies from taking on new projects, leading to a reduction in investment spending. This is linked to a contractionary monetary policy which tends to shift aggregate demand to the left, potentially leading to a decrease in real GDP rather than an increase.