Question

5. Explain the economic impact of a decrease in interest rates. Be sure use the concept taught in the course in your explanation.

6. What is the short-run trade-off in the response to a short-term supply shock? Why is this trade-off unavoidable?

Answer 1

5. Interest rates are inversely proportional to the Investment in the country and directly proportional to Savings. With decrease in interest rates opportunity cost of investment falls. Firms need to pay less against their loans hence the amount of investment increases. On the other hand public incentive to keep their money in the bank to earn higher rate of interest will fall. This causes a fall in savings as deposits in the bank. With fall in interest rates demand for money falls causing an increase in the money supply. This shifts the LM curve in the ISLM model to the right with IS curve undisturbed. This increases the GDP of the country.

6. The short term trade off referred to in this question is the trade between inflation and unemployment. The short run trade off is established by okun's law which states an inverse relation between output and unemployment which translates to the Phillip's curve which states inflation and unemployment are inversely related. To avoid this situation aggregate supply curve needs to shift to the right to increase. This would increase GDP and hence inflation reducing unemployment rate as greater workforce can be accomodated. But, in case of supply shock output falls and inflation increases leading to stagflation which means greater unemployment at a higher inflation. Thus, the trade off becomes unavoidable now.