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Assume firms become pessimistic about future profitability of spending on new informational technology. With everything else...

Assume firms become pessimistic about future profitability of spending on new informational technology. With everything else constant, this causes the output gap to become______ and inflation rate to_______. In order for the output gap to return back to zero and inflation rate to return back to its original rate, the Fed should ______ the real interest rate. :

A. negative; increase; decrease

B. positive; decrease; increase

C. negative; decrease; decrease

D. positive; increase; increase

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Answer #1

Answer : The answer is option A.

If firms become pessimistic then firms will decrease investment. As result, production will decrease which will decrease the aggregate supply. This will shift the AS (Aggregate Supply) curve to leftward. Due to decrease in aggregate supply the quantity will decrease and inflation rate will increase. This will create a negative output gap. Now if interest rate decrease then the borrowing cost decrease. As a result, firms will invest more. This will increase the aggregate supply which will shift back the AS curve. As a result, the output gap will be zero and inflation rate will back to the original rate. Hence the Fed should decrease the interest rate. Therefore, option A is the correct answer.

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