Question

Suppose there is a decrease in interest rates. Using the AD-AS model and starting at a long-run equilibrium, what would be the short-run effect?

Group of answer choices

A . A decrease in Real GDP, a decrease in the GDP Deflator

B. No change in Real GDP, an increase in the GDP Deflator

C. An increase in Real GDP, an increase in the GDP Deflator

D. No change in Real GDP, a decrease in the GDP Deflator

Answer 1

As AD-AS model is in a long run equilibrium. So any factor affecting the AD or AS will shift the curve and will change the equilibrium.

As, AD = C+I+G+NX

Since, A decrease in interest rate will reduce the cost of borrowing and will encourage the borrowings and hence will increase the investment spending.

So, With a decrease in interest rate the Investment (I) will rise. So this rise will also increase the AD as Investment (I) is a component of AD.

Now, Rise in AD with a constant AS will shift the AD curve rightwards as a result the Real GDP will increase.

• Hence, Option C. An increase in Real GDP, an increase in the GDP Deflator is correct.