Question

Suppose the economy is operating at the Zero Lower Bound for the nominal policy rate, the economy is operating at potential output in period t, but there is a large government budget deficit. A newly elected government vows to cut spending and reduce the deficit in period t+1, period t+2 and subsequent periods. Use an IS-LM-PC diagram and words to answer the following questions.

a. What is the effect of the policy on output in period t+1
b. What is the effect of the policy on the change in inflation in period t+1.
c. If expected inflation depends on past inflation, then what happens to the real policy rate in period t+2? How will this affect output in period t+3?
d. How does the ZLB on nominal interest rates make fiscal consolidation more difficult?

Answer 1