Question

During period of decline in economic activities (recessions) where unemployment rates are above the normal rates (more layoffs), would you consider a government’s decision to reduce interest rates a viable solution to stimulate the economy to employ more factors of production (capital and people)? Is it possible (or beneficial) to keep the interest rates low for a long period of time? Explain the mechanism in which lower or higher interest rates lead to lower unemployment.

Justify your answer for both the short-run and the long-run, keeping in mind the effect of inflation rates on such decision.

Answer 1

Ans

Yes in short run it is benificial. It is not beneficial because lower interest rates are achieved by higher money supply. This leads to inflation. To counter it monetary authority should increase interest rates. Also due to higher inflation real wages of labour falls. So labour demands higher wages. As a result Aggregate supply shifts leftwards. This results in fall in output and employment

lower interest rate increases employment and output because lower interest rate leads to higher inflation because interest rate and investment are inversely related