It has been argued that higher inflation causes business firms to become permane
ID: 1249343 • Letter: I
Question
It has been argued that higher inflation causes business firms to become permanently less efficient because they now have more pricing power. If this were true and economic output was initially at its potential level, then compared to the standard model, a fiscal expansion would cause:a. Disinflation.
b. Higher inflation than in the standard model.
c. Lower inflation than in the standard model.
d. What happens to inflation is indeterminate; it could be either higher or lower than in the standard model.
Explanation / Answer
Fiscal stimulus happens by way of increased government spending or by tax reduction. When a stimulus is given the Aggregate demand undoubtedly shifts towards its right. But in the above case the economy is running at potential GDP, when AD shits above potential GDP, there will be a ‘demand pull inflation’, increasing prices.
The economy cannot sustain at this level of above the potential or full employment level GDP for a long time due to limited supply of labor. This increases the aggregate expenditure hiking prices. Thus due to an increase in GDP higher than potential level increases the nominal GDP but Real GDP will not rise.
And as per the first statement 'It has been argued that higher inflation causes business firms to become permanently less efficient because they now have more pricing power'.
A higher inflation worsened by inefficiency to cause a much higher inflation than standard model.
If it is possible to increase or stimulate the GDP beyond potential GDP, every government will roll out a stimulus package to increase the standard of living.
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