Question

Explain how the Federal Reserve’s lowering of interest rates affects the following variables in the short run: household consumption, business investment, real GDP, and the price level. Insert or attach a well-labeled Aggregate Demand/Aggregate Supply graph that would illustrate the effect of a decrease in interest rates when the economy is in a recession in the Keynesian zone.

Answer 1

When the economy is in recession, there occurs a recessionary gap of Y1 - Y0. Lowering rate of interest will raise investment level because it will reduce the cost of borrowing for investors. Rise in investment will raise aggregate demand in economy and shift demand curve to its right from demand to new demand which will raise price level from P to P1 and raise output level from Y0 to Y1. Consumption by household will decrease because of rise in price level.