If sentiments deteriorate in the IS-MP model, then GDP decreases by:
A)less than in the IS-LM model.
B)the same as in the IS-LM model.
C)more than in the IS-LM model.
D)none of the above.

Question

Quizplus · Accepted Answer

In the IS-MP model, the central bank sets the nominal interest rate based on the inflation rate and the output gap. If sentiments deteriorate, it may decrease investment and increase savings, which leads to a decrease in the equilibrium real interest rate. As a result, the central bank needs to decrease the nominal interest rate to maintain the equilibrium, but if the nominal interest rate is already at zero, it cannot be decreased further. This "zero lower bound" constraint can lead to a larger decrease in GDP compared to the IS-LM model, where the central bank can decrease the nominal interest rate by increasing the money supply. Therefore, the correct answer is C.

If Sentiments Deteriorate in the IS-MP Model, Then GDP Decreases