Inflation - Adjustment of Inflation when an Expansionary Gap Exist

10 important questions on Inflation - Adjustment of Inflation when an Expansionary Gap Exist

What happens when an expansionary gap exists in terms of output?

When an expansionary gap is present, firms raise prices and output exceeds potential.

Why does the Federal Reserve raise interest rates during an expansionary gap?

Higher inflation prompts the Federal Reserve to increase real interest rates to control growth.

What impact do higher interest rates have on business and household spending?

Increased uncertainty leads to delayed investment and reduced major purchases by households.
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How does reduced spending affect output and unemployment levels?

Lower spending causes a decrease in output and a rise in cyclical unemployment rates.

What signals the restoration of long-run equilibrium in the economy?

Long-run equilibrium is restored when inflation stabilizes and output aligns with potential.

What happens to prices when an expansionary gap exists?

Firms respond by raising prices faster than costs increase due to excess demand.

What action does the Fed take in response to inflation during an expansionary gap?

The Federal Reserve increases real interest rates to slow the economy due to higher inflation.

How do higher interest rates affect business and household spending?

Uncertainty leads to delayed investment projects and cutbacks on major purchases.

What is the result of reduced spending in an expansionary gap?

Output decreases, moving closer to potential output, and cyclical unemployment increases.

What occurs when long-run equilibrium is restored?

Inflation stops rising, and the new equilibrium is at Y = Y* with stable inflation.

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