Reading 16 Q7 - Inflation and Output Gap

*Spoiler Alert* gonna give Q and A as well here, so if you haven’t done the question yet, go do it before reading this cuz I’m giving the answer here: The question is this:

  1. A) How might an analyst use the data reflected below to confirm her suspicion that the country is currently experiencing an output gap? The answer to this this one is fairly obvious - unemployment is super high, the gdp is dropping, so you reason that actual GDP is currently below potential GDP. Then question B throws me off. 7. B) Given your answer to part A, would you expect inflation over the next year to accelerate or decline? So the answer is that you would expect inflation to decline. My understanding is that in recessions, the government uses expansionary fiscal and monetary policy, increasing the money supply, and thus also increasing inflation, so I was thinking the government would do this, and inflation would follow. That said, the answer specifies “over the next year”. Am I to understand that the expansionary policy I am speaking of would take a while to actually have effect, and the recession will keep inflation low in the meantime? Or am I just completely missing something more critical? The actual answer in the text is this: Given the conclusion that the country is experiencing an output gap, an analyst would expect a further decline in the rate of inflation in the next year. Thanks

Yes, the impacts due to monetary policy are delayed, so you would not expect inflation to increase when the country experiences recessionary pressures and has an output gap.

For instance, during the global financial crisis of 2007-08, monetary policy bottomed out interest rates to near zero in the US. At the same time, and contrary to having an inflation increase, we actually had a small deflationary period for 2009. (see:

Great, glad I got that concept now, thanks

Agreed, it usually takes some time before decreases in interest rates are translated into increased investment spending. However the impact of impact of increased government spending is felt as soon as the spending takes place eg cuts in taxation feed through into the economy pretty quickly.