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.