Suppose we assume that initially if
Rises 2 percent and the real interest rate falls 2 percent, short-run output:
A) falls 2 percent.
B) rises 1 percent.
C) rises 3 percent.
D) falls 1 percent.
E) does not change.

Question

Suppose we assume that initially  if 
Rises 2 percent and the real interest rate falls 2 percent, short-run output:
A) falls 2 percent. 
B) rises 1 percent. 
C) rises 3 percent. 
D) falls 1 percent. 
E) does not change.

Quizplus · Accepted Answer

According to the Fisher effect, the nominal interest rate (i) equals the real interest rate (r) plus the expected inflation rate (π). If the nominal interest rate rises by 2 percent and the real interest rate falls by 2 percent, the expected inflation rate must also rise by 4 percent.

The increase in expected inflation rate will lead to an increase in aggregate demand and output in the short run, as consumers and firms will increase their spending due to the expectation of higher future prices. Therefore, short-run output will rise by 3 percent (2 percent due to the increase in expected inflation rate, and 1 percent due to the 2 percent rise in the nominal interest rate).

Suppose We Assume That Initially If