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Homework answers / question archive / If there is an inflationary gap in the short run, then in the long run a new equilibrium arises when input prices and expectations adjust upward, causing the short-run aggregate supply curve to shift upward and to the left and pushing equilibrium real GDP per year back to its long-run value
If there is an inflationary gap in the short run, then in the long run a new equilibrium arises when input prices and expectations adjust upward, causing the short-run aggregate supply curve to shift upward and to the left and pushing equilibrium real GDP per year back to its long-run value. However, the Federal Reserve can eliminate an inflationary gap in the short run by undertaking a policy action that reduces aggregate demand.
a. Propose one monetary policy action that could eliminate an inflationary gap in the short run.
b. In what way might society gain if the Fed implements the policy you have proposed instead of simply permitting long-run adjustments to take place?
Part a.
An inflationary gap exists when the demand for goods and services exceeds productive capacity (supply). The Fed can diminish an inflationary gap in the short run by raising interest rates at the short end of the curve (Fed funds rate). This action makes near term borrowing more costly and can have a ripple effect across longer dated debt instruments. By increasing the cost of borrowing, the Fed can decrease spending a close the gap between demand and productive capacity.
Part b.
The Fed intervention described above can be beneficial to society if it facilitates a steady long-term rate of inflation. Stability in prices and economic equilibrium (demand = supply) is conducive to prolonged expansionary cycles. Expansions are good for society; downturns and recessions are painful.
