According to new Keynesian theory, an increase in financial frictions might lead to ________, if ________.
A) a smaller decrease in output; expected inflation is reduced
B) a larger decrease in output; expected inflation rises
C) a decrease in inflation; the disruption of capital markets results in a leftward shift of long-run aggregate supply
D) a smaller decrease in output; a decline in expected output causes a leftward shift of aggregate demand

Question

Quizplus · Accepted Answer

An increase in financial frictions makes it more difficult for firms to borrow money to invest, which leads to a decrease in aggregate demand. If expected inflation is reduced, this will make the decrease in output smaller, as firms will be more likely to invest in the future.

According to New Keynesian Theory, an Increase in Financial Frictions