Question

a. Suppose that business pessimism leads to a reduction in investment demand. What are the short-run (immediate) effects on output, the unemployment rate, the real interest rate, consumption and investment?

b. If the nominal interest rate is reduced to the zero lower bound by the reduction in investment demand, what happens over time to inflation, output, the unemployment rate, and the real interest rate?

c. In this circumstance, discuss the ability of monetary and fiscal policies to restore full employment, that is, to return output and the unemployment rate to their natural rates.

Answer 1

Ans)
*a)* If there is a reduction in investment demand then in short run production of output decreses,demand for goods and services will also decrease due to reduction in income level. Because of low production activities all factors of productions are not utilised so it will create unemployment and rate of unemployment also increases.The real interest rate also decreases. As income level reduces, consumption also reduce s to some extent. If there is no excess income savings becomes impossible and therefore investment also decreseas.

*b)* Zero lower bound interest rate means the central bank cannot reduce interest rate further for economic growth,it is an expansionary monetary policy of central bank which results in high rate of inflation,it reduces unemployment rate and it also increases real interest rate.

*c)* Role of monetary and fiscal policy- In this situation money supply increases ,loans and advances are also available from banks for more activities of production.Unemployment rate also reduces as additional opportunities of employment gets created and fiscal policy measures also lightened for reduction of tax liabilities and increases real income of consumers.