The economy shown here begins at a 0% output gap. Now suppose that manufacturers in China face rising costs of rubber as an input. Based on the figure shown, if expected inflation was 2%, the actual inflation will be:

A)3%.
B)1%.
C)0%.
D)-1%.

Question

The economy shown here begins at a 0% output gap. Now suppose that manufacturers in China face rising costs of rubber as an input. Based on the figure shown, if expected inflation was 2%, the actual inflation will be:

A)3%. 
B)1%. 
C)0%. 
D)-1%.

Quizplus · Accepted Answer

As the cost of rubber for Chinese manufacturers increases, they will face a decrease in profitability and potentially lower output. This will lead to a decrease in aggregate supply (AS) and a shift to the left on the AS curve. With a decrease in output, the output gap will become negative, leading to an increase in actual inflation above expected inflation. Therefore, actual inflation will be higher than 2%, and the best answer choice is A.

The Economy Shown Here Begins at a 0% Output Gap