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?