Suppose the real interest rate is above the neutral real rate of interest but the economy is in an expansion. Which of the following options is consistent with these observations?

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BlackTom AI · Accepted Answer

To tackle the problem, I’ll lay out what each option would imply about the economy given that the real interest rate is above the neutral real rate while the economy is in an expansion.
Option 1: Positive cost-push shock. A cost-push shock raises production costs and typically pushes up prices, potentially slowing growth or triggering a weaker expansion or even a recession if the shock is large. In an environment where the real rate is above neutral, monetary policy is effectively tighter, which would further restrain demand. Thus, a positive cost-push shock is not the most consistent explanation for an ongoing expansion under a higher-than-neutral real rate.
Option 2: Positive spending shock. A positive spending shock means a sudden increase in aggregate demand (consumption, investment, or government spending). This boosts output and can sustain an expansion even when the real rate is above neutral, since the boost to demand can offset the restrictive effect of a higher policy rate. This scenario aligns with the observed combination of expansion and a real rate above neutral.
Option 3: Negative spending shock. A negative spending shock reduces demand, which would typically slow or reverse an expansion. With a real rate above neutral acting as a tightening motive, a negative spending shock would be even less compatible with an ongoing expansion.
Option 4: Negative cost-push shock. A negative cost-push shock lowers production costs and could help improve margins and growth, but by itself it is not a standard mechanism to generate or sustain an expansion when policy is relatively tight (real rate above neutral). While it could accompany expansion in some dynamic models, it is not the clean, direct explanation for the stated combination as much as a positive spending shock is.
Overall, the combination of an expansion with a real interest rate above the neutral rate is most consistent with an unexpected boost to spending—i.e., a positive spending shock—while the other options describe scenarios that would more likely dampen or fail to sustain growth under a relatively tight monetary stance.

ECO102H1 S LEC0101 Week 9 Quiz - Full Model

Suppose the real interest rate is above the neutral real rate of interest but the economy is in an expansion. Which of the following options is consistent with these observations?

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