Suppose households feel less optimistic about the future and decide to reduce consumption. This fall in consumer confidence will cause:
A) the natural real interest rate to rise.
B) the natural real interest rate to fall.
C) ambiguous effects on the natural real interest rate.
D) no effect on the natural real interest rate.
E) the natural real interest rate falls when the nominal rate falls.

Question

Quizplus · Accepted Answer

When households reduce consumption, it leads to a decrease in aggregate demand, which causes output and employment to fall. As a result, the central bank may decide to reduce interest rates to stimulate economic activity. This causes the natural real interest rate to fall, as it is the real interest rate that equilibrates saving and investment. Therefore, when consumers feel less optimistic about the future and reduce consumption, the natural real interest rate will fall, not rise or have ambiguous effects. Answer D and E are incorrect because a fall in consumer confidence will have an impact on the natural real interest rate. Answer A is incorrect because a fall in consumer confidence will lead to a fall, not a rise, in the natural real interest rate.

Suppose Households Feel Less Optimistic About the Future and Decide