Figure 8-5
-In the figure above, a crucial assumption that goes into positioning the SP curve in the bottom diagram is that
A) the wage rate is 1.00.
B) expected inflation is zero.
C) expected inflation is 5 percent.
D) the AD curve is AD1.
E) the shift of AD1 to AD2 will be repeated continuously.

Question

Figure 8-5 
-In the figure above, a crucial assumption that goes into positioning the SP curve in the bottom diagram is that
A) the wage rate is 1.00. 
B) expected inflation is zero. 
C) expected inflation is 5 percent. 
D) the AD curve is AD1. 
E) the shift of AD1 to AD2 will be repeated continuously.

Quizplus · Accepted Answer

The position of the short-run aggregate supply (SRAS) curve, and therefore the position of the potential GDP line and the long-run aggregate supply (LRAS) curve in the bottom diagram, are based on the assumption of expected inflation being zero. This is because the SRAS curve represents the level of output that firms are willing and able to produce at a given price level, assuming that input prices (including wages) are constant. If firms expect higher inflation, they will raise their prices in anticipation, causing a leftward shift of the SRAS curve. Therefore, assuming zero expected inflation is important in determining the equilibrium level of output and price in the short run.

Figure 8-5 -In the Figure Above, a Crucial Assumption That Goes into That