Answer: decreases and expected inflation remains the same.

## Explanation A neutral policy rate is one that neither stimulates nor contracts economic activity. It is typically defined as the sum of the trend growth rate and expected inflation (r* = trend growth + expected inflation). For a policy rate to become contractionary: 1. The actual policy rate must be **above** the neutral rate 2. OR the neutral rate itself must decrease while the policy rate remains unchanged Let's analyze each option: **Option A: increases and expected inflation increases** - If both trend growth and expected inflation increase, the neutral rate (r*) increases - If the policy rate remains unchanged, it would become **less contractionary** or even **expansionary** relative to the higher neutral rate - This would not make the policy rate contractionary **Option B: decreases and expected inflation remains the same** - If trend growth decreases while expected inflation remains the same, the neutral rate (r*) decreases - If the policy rate remains unchanged, it is now **above** the lower neutral rate - This makes the policy rate contractionary **Option C: decreases and expected inflation increases by the same amount** - If trend growth decreases and expected inflation increases by exactly the same amount, the neutral rate (r*) remains unchanged - The policy rate would remain neutral, not contractionary **Key Concept**: The neutral interest rate (r*) = trend growth rate + expected inflation rate. When the neutral rate falls (due to lower trend growth or lower expected inflation), an unchanged policy rate becomes contractionary because it's now above the neutral rate. **Correct Answer**: B - When trend growth decreases and expected inflation remains the same, the neutral rate decreases, making an unchanged policy rate contractionary.

Author: LeetQuiz .