The economy shown here begins at a 0% output gap. Now suppose that consumers fear a recession and reduce their spending. This leads to:

A)a new real interest rate of 3%.
B)unexpected inflation of 1%.
C)a new output gap of -4%.
D)a new real interest rate of 0%.

Question

The economy shown here begins at a 0% output gap. Now suppose that consumers fear a recession and reduce their spending. This leads to:

A)a new real interest rate of 3%. 
B)unexpected inflation of 1%. 
C)a new output gap of -4%. 
D)a new real interest rate of 0%.

Quizplus · Accepted Answer

When consumers reduce their spending, it leads to a decrease in aggregate demand, which in turn leads to a decrease in output and an increase in unemployment. This decrease in output is reflected in the output gap, which is the difference between the actual level of output and the potential level of output. Therefore, a reduction in consumer spending would lead to a new output gap of -4%.

The Economy Shown Here Begins at a 0% Output Gap