The economy shown here begins at a 0% output gap. Now suppose that consumers fear a recession and reduce their spending. If inflation expectations remain unchanged, the actual inflation rate will be:

A)2% higher.
B)1% higher.
C)1% lower.
D)4% lower.

Question

The economy shown here begins at a 0% output gap. Now suppose that consumers fear a recession and reduce their spending. If inflation expectations remain unchanged, the actual inflation rate will be:

A)2% higher. 
B)1% higher. 
C)1% lower. 
D)4% lower.

Quizplus · Accepted Answer

If consumers reduce their spending, the demand for goods and services will decrease, causing a decrease in output and an increase in unemployment. This will lead to a negative output gap, which will put downward pressure on prices. If inflation expectations remain unchanged, the actual inflation rate will be lower than before, as there is less demand for goods and services in the economy. Therefore, the actual inflation rate will be 1% lower.

The Economy Shown Here Begins at a 0% Output Gap