Question

Australia is facing an inflationary gap but the Reserve Bank of Australia decides not to take any monetary policy action. Explain the long‐run outcome and the process that leads to that outcome

Answer 1

If there is an inflationary gap in the economy it indicates that the present level of balance GDP is more than the long-run stability level of GDP. Due to this reason, there is demand-pull inflation and unemployment is extremely low. If this inflationary gap continues to dominate and there is no action from the government or the Reserve Bank, in the long run, due to the fact that the price level has actually been greater, companies will be revising small incomes in order to keep the real wages unchanged. Increase nominal salaries suggests reduced earnings and therefore production will be reduced.

Short-run Aggregate supply curve, in the long run, will be shifting to the left, which will, even more, increase the price level. Nevertheless, the genuine GDP will go back to its long-run equilibrium value. This suggests that in the long run, the economy will self-change, reaching its long-run equilibrium level of output at a greater price level.