What are the possible effects of a decrease in the interest rate set by the central bank?
A decrease in the real interest rate will reduce the cost of borrowing for firms, so these firms will tend to borrow more to finance investment. There may also be a consumption effect if consumers decide to spend more and save less in response to lower interest rates. Investment and consumption will both be higher. As AD = C + I + G + (X-M), then an increase in consumption and investment will lead to higher aggregate demand. In an AD/AS diagram, this would be shown by an outwards shift in the AD curve leading to higher output and a higher general price level.
[then draw diagram on whiteboard]
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