Suppose that the Federal Reserve has decided that there is a deflationary gap of $1 trillion in the economy. Suppose further that the estimated slope of the IS curve is -$400 billion. By how many percentage points would the Fed need to decrease the real interest rate in order close the deflationary gap?
A) 2.5
B) 4
C) .4
D) 25

Question

Quizplus · Accepted Answer

To close a deflationary gap of $1 trillion with an IS curve slope of -$400 billion, the Fed would need to adjust the real interest rate by the gap amount divided by the slope of the IS curve. This calculation is $1 trillion / $400 billion = 2.5, meaning the Fed would need to decrease the real interest rate by 2.5 percentage points.

Suppose That the Federal Reserve Has Decided That There Is