Refer to the accompanying figure. Starting from long-run equilibrium at point C, a favorable inflation shock that decreases inflation from π to π¹ will lead to a short-run equilibrium at point ________ and eventually to a long-run equilibrium at point ________, if left to self-correcting tendencies.
A)A; B
B)A; C
C)B; A
D)B; C

Question

Refer to the accompanying figure.  Starting from long-run equilibrium at point C, a favorable inflation shock that decreases inflation from π to π¹ will lead to a short-run equilibrium at point ________ and eventually to a long-run equilibrium at point ________, if left to self-correcting tendencies.
A)A; B 
B)A; C 
C)B; A 
D)B; C

Quizplus · Accepted Answer

A favorable inflation shock is modeled as a downward shift of the SRAS curve. In the short run, this results in lower inflation and higher output at point A. As a result of this expansionary gap, inflation will gradually start to increase again - shifting the SRAS line back up. When inflation has again risen enough, the economy is back in long-run equilibrium at C.

Refer to the Accompanying Figure