Figure 12.8: Output
-Consider Figure 12.8. You are chairman of the Federal Reserve in 1995. You believe potential output follows the dotted line after 1993, 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; boom; accelerates a recession
C) keep interest rates the same; boom; accelerates inflation
D) lower interest rates; boom; increases unemployment
E) Not enough information is given.

Question

Figure 12.8: Output 
-Consider Figure 12.8. You are chairman of the Federal Reserve in 1995. You believe potential output follows the dotted line after 1993, 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; boom; accelerates a recession 
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

Since the chairman of the Federal Reserve believes that the economy is in a boom, but in reality it is below the potential, the best course of action would be to raise the interest rates. This would slow down the economy and reduce the risk of inflation, which would likely occur if the economy continues at its current pace. Moreover, lowering interest rates would stimulate the economy, which would lead to even greater deviations from potential and a greater risk of an economic downturn in the future.