Question

An important part of the “tech bust” in 2001 was that firms became more pessimistic about the future profitability of internet-related investment projects. In response, they substantially reduced their purchases of network equipment and software.

1. What effect will this “increased pessimism” have on long-term interest rates and the aggregate level of investment spending?   Discuss the initial shock, and describe how long-term real interest rates will change to bring about a new equilibrium.

Answer 1

Initially, when firms become pessimistic and do not spend in investments it will reduce the aggregate level of investment spending and therefore reduce the injuction of money in the market and the aggregate demand.

To bring back the equilibrium, the long term interest rates will eventually fall, so that firms will again start spending on investments. The reduced interest rate will act as a booster for firms to invest again and the equilibrium will be met again.