Suppose that the real interest rate suddenly declines
for reasons that have nothing to do with the value of the price level. What happens to the nation's aggregate demand curve, shift left or right? In the short run, will the nation experience an inflationary gap or a recessionary gap? Explain.
In the short run, the equilibrium price level will---and the nation will experience---gap because desired investment---and the short-run equilibrium level of real GDP per year is---real GDP at full employment
If the real interest rate suddenly declines for reasons unrelated to the price level, this will cause the aggregate demand curve to shift to the right. This is because a lower interest rate will encourage businesses and individuals to borrow and spend more money, leading to an increase in overall demand for goods and services.
In the short run, this shift in the aggregate demand curve may result in an inflationary gap or a recessionary gap, depending on the state of the economy. If the economy is operating below full employment, the increase in demand may lead to an inflationary gap, where prices rise as firms struggle to meet the increased demand. On the other hand, if the economy is already operating at or above full employment, the increase in demand may not lead to increased production and employment, resulting in a recessionary gap.
In the short run equilibrium, the price level will increase and the nation will experience an inflationary gap if the economy is operating below full employment. Conversely, if the economy is already at full employment, the increase in demand will not result in increased production, and the nation will experience a recessionary gap. The short-run equilibrium level of real GDP per year will be higher than the initial level due to the increase in demand, but it will not be at full employment due to the presence of the inflationary or recessionary gap.
If the real interest rate suddenly declines for reasons unrelated to the price level, it leads to a rightward shift of the nation's aggregate demand (AD) curve.
In the short run, this will result in an inflationary gap. The equilibrium price level will increase, and the nation will experience a higher level of overall output than the full employment level. This is because the decline in the real interest rate increases investment spending, which in turn increases aggregate demand. As a result, the economy operates at a level above the full employment level of real GDP per year.
It is important to note that the short-run equilibrium level of real GDP per year falls below the actual level of real GDP at full employment. This gap between the short-run equilibrium and the full employment level of real GDP is known as an inflationary gap.