Suppose a natural disaster wipes out a significant portion of the economy’s capital stock, reducing the potential level of output. What would you expect to happen to the long-run real interest rate, r*? The reduction in the economy’s potential level of output would lead to (Click to select) ?y in the long-run real interest rate. This would (Click to select) ?the interest-sensitive components of aggregate expenditure to equate aggregate expenditure with potential output. What impact would this have on the monetary policy reaction curve and the dynamic aggregate demand curve? The monetary policy reaction curve would (Click to select)y, ?as (Click to select) ?v real interest rate would be associated with each level of inflation. Therefore, the level of output would be (Click to select) ?~ at each level of inflation and the dynamic aggregate demand curve would (Click to select).
The Correct Answer and Explanation is:
Answer:
The reduction in the economy’s potential level of output would lead to a decrease in the long-run real interest rate, r∗r^*. This would increase the interest-sensitive components of aggregate expenditure to equate aggregate expenditure with potential output. The monetary policy reaction curve would shift down, as a lower real interest rate would be associated with each level of inflation. Therefore, the level of output would be lower at each level of inflation and the dynamic aggregate demand curve would shift left.
Explanation:
A natural disaster that destroys a significant portion of the economy’s capital stock reduces the economy’s productive capacity, which means the potential level of output (Y*) declines. Potential output is tied closely to the available capital, labor, and technology, so a loss in capital reduces Y∗Y^*.
- Effect on the long-run real interest rate r∗r^*:
The long-run real interest rate reflects the equilibrium return on capital where savings and investment balance at full employment. When capital stock is reduced, the marginal product of capital (MPK) changes, but overall, less capital means the economy has a lower capacity to produce and invest. This tends to reduce the demand for investment funds, which pushes down the equilibrium real interest rate r∗r^*. - Impact on aggregate expenditure:
Since the potential output is lower, aggregate expenditure must adjust accordingly to meet this new, lower level. A lower real interest rate makes borrowing cheaper and encourages interest-sensitive spending components (like investment and durable consumption) to increase, helping to bring aggregate expenditure back in line with the new, reduced potential output. - Monetary policy reaction curve:
Central banks typically adjust nominal interest rates in response to inflation and output gaps. Because the natural real interest rate r∗r^* is lower, the central bank’s policy reaction curve shifts downward—at any given level of inflation, the real interest rate set by the central bank is lower than before. This reflects easier monetary conditions consistent with the new economic reality. - Dynamic aggregate demand (AD) curve:
The AD curve represents combinations of inflation and output where the goods market and money market clear. With potential output reduced, and a lower natural interest rate, the dynamic AD curve shifts left, indicating that for any given inflation rate, the equilibrium output level is lower. This is consistent with the economy operating on a reduced scale.
In summary, a natural disaster reducing capital stock lowers potential output and the natural real interest rate. This leads to easier monetary conditions (lower policy interest rates for given inflation) and a leftward shift in the aggregate demand curve, signaling a permanently smaller economy at each inflation level.
