This argument is based on the following reasoning: A negative aggregate demand shock leads to a drop in the price level to below the target path. If the central bank’s commitment to the price-level target is credible, the private sector anticipates that the price level will return to its target.
Hence, a drop in the price level will lead to an automatic rise in inflation expectations. This movement of inflation expectations mitigates the effect of the original shock on the inflation rate. Consequently, for a given nominal interest rate, the real interest rate decreases. This stimulates aggregate demand and, in turn, keeps the required nominal interest reduction to a minimum.