Final answer:
Option A is the correct answer. The effect of a fall in consumer spending on the economy typically leads to a rise in the real interest rate, falling output, and unexpected deflation. A rise in the supply of money in the financial market will lead to a decline in interest rates. Deflation increases the real interest burden on borrowers, which can cause a recession.
Step-by-step explanation:
When analyzing the effect of a fall in consumer spending on the economy using the Fed model, the scenario that typically unfolds is a decline in aggregate demand. This, in turn, can lead to a reduction in output, or economic contraction. Moreover, the real interest rate tends to rise due to deflationary pressures caused by the reduced spending. Consequently, the correct answer to the impact of a decrease in consumer spending is: A. a rise in the real interest rate, falling output, and unexpected deflation.
As for changes in the financial market that could lead to a decline in interest rates, an increase in the money or loanable funds supply would cause interest rates to fall. Therefore, the relevant option is: C. a rise in supply.
Understanding the relationship between nominal and real interest rates is also crucial. For example, if the nominal interest rate is 7% and the rate of inflation is 3%, then the effective real interest rate is 4%. Conversely, with a 7% nominal rate and deflation of 2%, the real interest rate would be 9%, which represents an unexpected increase for the borrower due to deflation. This can have far-reaching negative consequences for both the borrowers and the banks, potentially leading to a recession.