Fiscal consolidation at the Zero Lower Bound Suppose the economy is operating at the zero lower bound for the nominal policy rate; there is a large government deficit and the economy is operating at potential output in period \(t\). A newly elected government vows to cut spending and reduces the deficit in period \(t+1\), period \(t+2\) and subsequent periods.

a. Show the effects of the policy on output in period \(t+1\).

b. Show the effects of the policy on the change in inflation in period \(t+1\).

c. If expected inflation depends on past inflation, then what happens to the real policy rate in period \(t+2\) ? How will this affect output in period \(t+3\) ?

d. How does the zero lower bound on nominal interest rates make a fiscal consolidation more difficult?