Question

The following table gives an example of an inflation adjustment line. Real GDP (percent deviation from...

The following table gives an example of an inflation adjustment line.



Real GDP
(percent deviation
from potential GDP)



Inflation
(percent per year)



3.0



2.0



2.0



2.0



1.0



2.0



0.0



2.0



-1.0



2.0



-2.0



2.0



-3.0



2.0

Sketch the line in a graph.

If real GDP is above potential GDP, will the inflation adjustment line shift up or down? Explain.

In the same graph as part (a), sketch in the aggregate demand curve given in Problem 5. Find the equilibrium level of real GDP and inflation.

Show what happens to the inflation adjustment line if inflation expectations suddenly increase.

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Answer #1

When real GDP is greater than potential GDP this is known as inflationary gap. The line will shift up.In this situation the economy experience inflation. Firms on seeing greater demand increase the prices. Workers on seeing low unemployment demands higher wages and hence inflation rises in the economy.

An inflation adjustment line will shift upwards when inflation expectations suddenly increase. This is due to the effect of change in expectations that workers raise their wages and prices.

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