Question

Refer to the figure below. Suppose the economy is in a short-run equilibrium at output Y₃ and inflation rate π_2. The economy is currently experiencing ______, and the correct monetary policy response to this situation, to return the economy to potential GDP, is to _______.

_{Inflation rate ASI AS2 AD AD2 Output}

Select one:

a. a recessionary gap; raise taxes

b. an expansionary gap; cut taxes

c. a recessionary gap; increase the money supply

d. an expansionary gap; decrease the money supply

Answer 1

We are given that there is currently a short-run equilibrium at output Y₃ and inflation rate π₂ so that it is determined by AD1 and AS2. Potential GDP is Y* = Y2. Since Y3 is greater than Y2, currently there is an inflationary gap (expansionary gap or positive output gap). The correct policy response to this situation is to inact a monetary or fiscal contraction. This can be done in the form of raising taxes or reducing government spending in fiscal policy and reduction in money supply in monetary policy

Select D.