Assume that the economy starts at a 0% output gap. Now suppose that consumers fear a recession and reduce their spending. Based on this scenario, the economy experiences:

Figure A

Figure B

Figure C

Figure D

A) no change, as shown in Figure A.
B) an upward shift of the MP curve and a new interest rate of 3%, as shown in Figure B.
C) a leftward shift of the IS curve and an output gap of -4%, as shown in Figure C.
D) an upward shift of the Phillips curve and 1% unexpected inflation, as shown in Figure D.

Question

Assume that the economy starts at a 0% output gap. Now suppose that consumers fear a recession and reduce their spending. Based on this scenario, the economy experiences:
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Figure A
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Figure B
 ​
Figure C
 ​
Figure D

A) no change, as shown in Figure A. 
B) an upward shift of the MP curve and a new interest rate of 3%, as shown in Figure B. 
C) a leftward shift of the IS curve and an output gap of -4%, as shown in Figure C. 
D) an upward shift of the Phillips curve and 1% unexpected inflation, as shown in Figure D.

Quizplus · Accepted Answer

If consumers reduce their spending due to fear of a recession, this leads to a decrease in consumption expenditure, which causes the IS curve to shift leftward. As a result of this shift, the equilibrium output decreases and the output gap becomes negative (-4% in this case) as shown in Figure C. There is no change in the interest rate, so options A and B can be eliminated. Option D is irrelevant as it pertains to inflation, which is not discussed in the scenario. Therefore, the correct answer is C.

Assume That the Economy Starts at a 0% Output Gap