PS3 - My P Le EC224 Problem Set 3 1. a. As e becomes...

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My P Le EC224 Problem Set 3 1. a. As ∏e becomes negative, r is now higher at any given i. This increase in the real interest rate depresses planned investment spending, thus shifting the IS curve down from IS to IS1. Thus, an expected deflation leads to reduction in national income from Y to Y1. The nominal interest rate falls from i to i1. This happens because when firms come to expected deflation, they become reluctant to borrow to invest as they believe they will have to repay these loans later in more expensive dollars. The fall in investment depresses planned expenditure, which in turn depresses income. The fall in income reduces demand for money, thus reduces the nominal interest rate. The nominal interest rate falls by less than the expected deflation, so the real interest rate rises. (Actually, firms need time to change their output. So immediately, as they cut down on borrowing and shifting IS down, they still keep their level of output at Yo (thus, i has to fall significantly). As customers buy less, inventories rise. However, in the next period, they reduce their output to Yo, causing i to rise, but not to the original level. Economy moves from Eo to E’ and to E1).
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b. c.
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This note was uploaded on 10/27/2011 for the course ECON 125 taught by Professor Diannelabert during the Spring '11 term at Hamilton College.

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PS3 - My P Le EC224 Problem Set 3 1. a. As e becomes...

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