Question

C) Suppose the economy is operating at the zero lower bound for the nominal policy rate; the initial equilibrium is at the positive target rate of inflation and the economy is resting at potential output but there is a large government deficit in period t. A newly elected government vows to cut spending and permanently reduces the deficit by cutting G in period t + 1 and subsequent periods. Explain how the zero lower bound on nominal interest rates makes a fiscal consolidation more difficult. In doing so, illustrate the short-run and medium-run impacts using the IS-LM-PC model. Analyze how this policy lead to a deflation spiral. (40 Marks)

          C) Suppose the economy is operating at the zero lower bound for the nominal policy rate; the initial equilibrium is at the positive target rate of inflation and the economy is resting at potential output but there is a large government deficit in period t. A newly elected government vows to cut spending and permanently reduces the deficit by cutting G in period t + 1 and subsequent periods.

Explain how the zero lower bound on nominal interest rates makes a fiscal consolidation more difficult. In doing so, illustrate the short-run and medium-run impacts using the IS-LM-PC model. Analyze how this policy lead to a deflation spiral. (40 Marks)

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