Question

Following the economic and financial events of 2008 that pushed the US economy in a deep recession, the Federal Reserves acted to decrease the short-term interest rate to historically low levels.

a) Explain in words what effect did the Fed hope the action would have on output (Y), consumption (C) and investment (I).

b) Explain in words which curves shift AND in which direction in the Keynesian cross graph and in the IS-Fed Rule graph.

Answer 1

a) Decreasing interest rate will trigger huge investments in the economy , since interest rate is the price of investment . This is rise production and hence growth of output . Consumption demand for goods and services will also increase . Since interest rate has fallen , people will lose interest in savings, so they will start to consume more and save less .

b) A fall in interest rate will shift IS curve leftwards and LM curve rightwards . In Keynesian cross graph the aggregate expenditure curve will move upwards .