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Inflation in the country of Hypothetica is currently 5%, below the target range of its central...

  1. Inflation in the country of Hypothetica is currently 5%, below the target range of its central bank.
  1. What does this tell you regarding Hypothetica’s likely output gap? Illustrate it using an AS-AD diagram, and briefly explain your diagram                  
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Answer #1

ANSWER:-

Given that:-

Inflation in the country of Hypothetica is currently 5%, below the target range of its central bank.

i).

A lower-than-target inflation means aggregate demand is low. The economy is in recession with a negative output gap.

In following graph, long-run equilibrium is at point A where initial aggregate demand (AD0) intersects initial short-run aggregate supply cruve (SRAS0) and long-run aggregate supply cruve (LRAS0), with long-run equilibrium price level P0 and real GDP (= potential GDP) Y0.

During recession, economy is at point B where aggregate demand is to the left of LARS at AD1, intersecting SRAS0 with lower price level P1 and lower real GDP Y1. Short-run Recessionary gap is (Y0 - Y1).

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