Figure 12.7: Output
-Consider Figure 12.7. You are chairman of the Federal Reserve in 1975. You believe potential output follows the dotted line after 1973, but in actuality, it follows the line denoted "True potential output." The current state of the economy is given by the curve "Actual output." Given the information in the figure, you ________, because you believe the economy is in a ________, but your advice instead ________.
A) lower interest rates; recession; accelerates inflation
B) raise interest rates; recession; accelerates inflation
C) keep interest rates the same; boom; accelerates inflation
D) lower interest rates; boom; increases unemployment
E) Not enough information is given.

Question

Figure 12.7: Output 
-Consider Figure 12.7. You are chairman of the Federal Reserve in 1975. You believe potential output follows the dotted line after 1973, but in actuality, it follows the line denoted "True potential output." The current state of the economy is given by the curve "Actual output." Given the information in the figure, you ________, because you believe the economy is in a ________, but your advice instead ________.
A) lower interest rates; recession; accelerates inflation 
B) raise interest rates; recession; accelerates inflation 
C) keep interest rates the same; boom; accelerates inflation 
D) lower interest rates; boom; increases unemployment 
E) Not enough information is given.

Quizplus · Accepted Answer

If you believe potential output is higher than it actually is (following the dotted line rather than the "True potential output" line), you would think the economy is underperforming (in a recession) when it might actually be at or above its true potential. Lowering interest rates is a common response to stimulate an economy perceived to be in a recession. However, if the economy is already operating at or near its true potential, stimulating it further could lead to inflationary pressures, hence accelerating inflation.