Question

Over the medium run, the economy converges to the potential level of output and stable inflation. Q: why does output decrease as the economy moves from A to A’? Q: what should the central bank do to reduce inflation?

Answer 1

Q1)

Output decreases by moving from A to A’; it decreases by (Y0 – Yp). This happens because at A point the economy has inflationary gap since LRAS is in the left side of A.

Q2)

The central bank should take contractionary monetary policy in this regard. Under this policy, money supply in the economy would be low, people don’t have enough money to purchase or invest, making the inflation down; it happens above, since price becomes lower as P1.