Suppose the central bank thinks potential GDP is growing at 2% per year but it is actually growing more slowly at 1%. Will this tend to increase or decrease inflationary pressure in the economy (for a given growth rate of the money supply)?Group of answer choicesIncreaseDecrease
Question
Suppose the central bank thinks potential GDP is growing at 2% per year but it is actually growing more slowly at 1%. Will this tend to increase or decrease inflationary pressure in the economy (for a given growth rate of the money supply)?Group of answer choicesIncreaseDecrease
Solution
If the central bank overestimates the growth of potential GDP, it might implement a monetary policy that is too loose for the actual state of the economy. This means that the bank might increase the money supply too much, thinking that the economy can absorb this extra money without causing inflation.
However, if the economy is actually growing more slowly, it cannot absorb all the extra money. This excess money can lead to increased demand for goods and services. If the supply of these goods and services cannot keep up with the increased demand (which is likely if the economy is growing more slowly than expected), prices will start to rise. This is inflation.
Therefore, if the central bank thinks potential GDP is growing at 2% per year but it is actually growing more slowly at 1%, this will tend to increase inflationary pressure in the economy.
Similar Questions
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