Suppose that you were a forecaster of the real wage rate, output, the real inter

Question

Suppose that you were a forecaster of the real wage rate, output, the real interest rate, the price level and investment. A shock hits the economy, which you interpret as people expecting their future income to fall. Using the long-run (after the adjustment of P is complete) version of the IS-LM model, your prediction is that:

A Y, and w are unchanged, r and P decline, and I rises.

B Y, and w are unchanged, r and P rise, and I declines.

C Y and w decline, r and P decline, and I rise.

D Y and w decline, r and P rise, and I declines.

Explain your answer.

Explanation / Answer

The correct answer is C Y and w decline, r and P decline, and I rise.

Due to the change in public expectation, the aggregate demand curve will shift to the left. This means that the price will go down and the IS curve shifts to the left. This means a lower interest rate with lower output Y.

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