Question

Explain why a zero lower bound limit on nominal interest rates can cause a bend in the Aggregate Demand Curve. Draw a graph to show one way in which this might be a problem for the economy or for managing the economy.

Answer 1

The Fishers equation relates the nominal interest rate to the real interest rate. Thus it is given by r=i-P, where r is the real interest rate, i is the nominal interest rate and P is the expected inflation rate. The aggregate demand curve is formed with this equation in mind. Now if the nominal interest rate has a 0 lower bound limit, then given the inflation rate the real interest rate can be negative.As real interest rates become negative if nominal interest rates are 0, the aggregate demand curve will become steeper as the output level responds less to changes to the price level beyond that point. Given this, managing the economy becomes tougher as the output level changes less. This is given as follows as beyond price level P1 the AD curve becomes steeper.