Suppose an economy that has been operating at full employment has been experiencing 4 percent annual inflation. If output later falls to a level that is less than potential output, prices generally will begin to rise at
A) a rate of 4 percent.
B) a rate greater than 4 percent.
C) a rate less than 4 percent.
D) a rate of 0 percent.

Question

Quizplus · Accepted Answer

If output falls below potential output, there will be a decrease in demand for goods and services, leading to a decrease in prices. Additionally, the decrease in output will lead to a decrease in the demand for labor, which will result in an increase in unemployment. The increase in unemployment will decrease the bargaining power of workers and reduce their ability to demand increases in wages. As a result, businesses will not face pressure to increase prices, and therefore, prices will rise at a rate less than 4 percent.

Suppose an Economy That Has Been Operating at Full Employment