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:
Correct Answers:
- The reduction in the economy’s potential level of output would lead to an increase in the long-run real interest rate.
- This would reduce the interest-sensitive components of aggregate expenditure to equate aggregate expenditure with potential output.
- The monetary policy reaction curve would shift left, as a higher 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
When a natural disaster destroys a significant portion of the economy’s capital stock, the economy’s productive capacity declines. This lowers *potential output (Y)**, which represents the maximum sustainable level of real GDP the economy can produce given its resources and technology.
In the long run, equilibrium in the goods market requires that aggregate expenditure equals potential output. With a lower Y*, for equilibrium to be restored, actual spending must fall. One way this happens is through an *increase in the long-run real interest rate (r)**, which discourages interest-sensitive components of aggregate expenditure—such as investment and durable consumption. This contraction in spending helps align aggregate demand with the reduced potential output.
The rise in the equilibrium real interest rate also affects monetary policy. Central banks adjust nominal interest rates to achieve real rates consistent with their objectives. If r* rises, the monetary policy reaction function (or Taylor-type rule) must adjust. Specifically, at each level of inflation, a higher real interest rate is now required to stabilize the economy. Thus, the monetary policy reaction curve shifts left (or becomes steeper), reflecting a tighter stance at any given inflation rate.
Consequently, the dynamic aggregate demand (DAD) curve, which captures the inverse relationship between inflation and output over time, also shifts to the left. With tighter monetary policy and higher r*, the same inflation rate now results in lower output, reflecting reduced spending and investment.
In summary, a reduction in capital stock and potential output leads to higher real interest rates, lower aggregate demand, a leftward shift of the monetary policy reaction curve, and a leftward shift of the DAD curve, all aiming to realign the economy to its new, lower capacity.
