Suppose the economy is operating at the Zero Lower Bound for the nominal policy rate, the...

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?

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Rahul Sunny answered 1 year ago

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