Suppose we assume
,
,
,and the real interest rate rises to
)The economy would
A)remain at its long-run equilibrium.
B)move from 1 percent below its potential to its longrun equilibrium.
C)move from its long-run equilibrium to 1 percent above its potential.
D)move from its long-run equilibrium to 1 percent below its potential.
E)none of the above

Question

Suppose we assume 
, 
, 
,and the real interest rate rises to 
)The economy would
A)remain at its long-run equilibrium. 
B)move from 1 percent below its potential to its longrun equilibrium. 
C)move from its long-run equilibrium to 1 percent above its potential. 
D)move from its long-run equilibrium to 1 percent below its potential. 
E)none of the above

Quizplus · Accepted Answer

An increase in the real interest rate would increase the cost of borrowing to firms and households, leading to a decrease in investment and consumption spending. This decrease in aggregate demand would lead to a decrease in output and an increase in unemployment in the short run. As output falls below its potential level, there would be downward pressure on prices and wages, leading to a decrease in inflation. This decrease in inflation would cause the nominal interest rate to fall, which would further decrease the real interest rate. The economy would continue to adjust until the real interest rate rose to a level that is consistent with the long-run equilibrium. 
Therefore, the economy would move from its long-run equilibrium to 1 percent below its potential in the short run.

Suppose We Assume