The following table describes the aggregate demand curve, where real GDP is expressed as the percent deviation from potential GDP, and inflation is expressed as a percentage.Real GDP Inflation2.0 3.01.0 4.00.0 5.0–1.0 7.0–2.0 9.0Due to a price shock, inflation increases by 2%. In the long run, what will inflation be?
Question
The following table describes the aggregate demand curve, where real GDP is expressed as the percent deviation from potential GDP, and inflation is expressed as a percentage.Real GDP Inflation2.0 3.01.0 4.00.0 5.0–1.0 7.0–2.0 9.0Due to a price shock, inflation increases by 2%. In the long run, what will inflation be?
Solution
The question is asking for the long-run inflation rate after a price shock that increases inflation by 2%.
From the table, we can see that the inflation rate increases as the real GDP decreases. This is because when the economy is below its potential (negative real GDP), there is less supply of goods and services which leads to higher prices (inflation).
Given that the price shock increases inflation by 2%, we need to find out what the new inflation rate will be.
To do this, we need to look at the initial inflation rate before the shock. However, the question does not provide this information.
If we assume that the economy was at its potential before the shock (real GDP = 0.0), then the initial inflation rate was 5.0%.
After the shock, the inflation rate would increase by 2% to 7.0%.
So, in the long run, if the economy returns to its potential, the inflation rate will be 7.0%.
However, if the economy does not return to its potential and instead stays below it (negative real GDP), the inflation rate could be higher. For example, if real GDP is -1.0, the inflation rate could be 9.0%.
Therefore, without more information about the state of the economy after the shock, we cannot definitively say what the inflation rate will be in the long run. But we can say that it will be at least 7.0%.
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