Assume the economy is in equilibrium. If the interest rate falls, what sequence of events will return the economy to equilibrium?
A) Total spending rises as investors move funds into foreign assets, causing the exchange rate to rise (depreciate), and the trade balance increases, causing output to rise.
B) Savers save more to replace lost interest earnings, consumption falls, imports rise, and the trade balance falls, causing output to fall.
C) Total spending falls, unemployment rises, government transfers increase, inflation rises, and the exchange rate falls (appreciates).
D) Bond prices rise, causing foreign investment to flow in, causing the exchange rate to fall (appreciate).

Question

Quizplus · Accepted Answer

When the interest rate falls, it generally makes borrowing cheaper, which can lead to an increase in spending and investment. This can lead to a depreciation of the exchange rate (making domestic goods cheaper for foreigners and foreign goods more expensive for domestic consumers), which can improve the trade balance and increase output, moving the economy back towards equilibrium.

Assume the Economy Is in Equilibrium