Question

How does the policy rate hitting a floor of zero lead to an upward-sloping aggregate demand curve?

Short answer

When the policy rate reaches zero, the nominal interest rate is also set at zero, lead to an upward-sloping aggregate demand curve.

Step-by-step solution

Step 1. Introduction

The aggregate demand curve is a graphical representation of all the commodities and services that are requested at various price levels in the economy.

Step 2. Explanation

The interest rate charged to the borrower as a percentage of the loan is known as the policy rate. When the policy rate reaches zero, the nominal interest rate is also set at zero, resulting in lower inflation. This low inflation rate leads to high real interest rates, which in turn causes planned expenditures to fall short of expectations, resulting in a drop in aggregate output. Inflation will reduce as aggregate output falls, resulting in an upward hitting aggregate demand curve.