Inflation - Adjustment of Inflation when a Recessionary Gap Exist

5 important questions on Inflation - Adjustment of Inflation when a Recessionary Gap Exist

What happens to prices when a recessionary gap exists?

Firms lower prices to attract more buyers, causing inflation rate (π) to fall.

How does the Federal Reserve respond to lower inflation?

It cuts real interest rates, encouraging more investment and consumption to boost Aggregate Demand (AD).

What effect does lower inflation have on uncertainty?

It makes future prices more predictable, which raises consumer and business confidence.
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What occurs as Aggregate Demand increases during a recessionary gap?

Output (Y) increases and unemployment falls, moving closer to potential output.

What signifies the restoration of long-run equilibrium?

The process continues until output reaches Y* and inflation stabilizes at a sustainable level.

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