5 The following diagram shows an economy where monetary poli

5. The following diagram shows an economy where monetary policy has reached the lower zero bound (LZB). Inflation Ratte. (percent) RAS AD, AS Aggregate ouiput, YS trilions curve to shiftmoving the economy the potential level of output. (a) (b) In the ZLB the \"self-correcting\" mechanism of the cconomy will cause the Expansionary fiscal policy is more effective when the economy is below the ZLB than when it is above the ZLB since it causes the to fall, resulting in a multiplicr effect.

Solution

a) In case of ZLB, the self-correcting mechanism will not work; the economy will have a negative output gap

Inflation & output fall; inflation & nominal rate fall

AS curve shifts to the left; inflation & output fall

b) output, inflation & real interest rate to fall

positive / clear Government expenditure multiplier effect