Based on the figure below, an economy in short-run equilibrium at point A has a(n) _______ gap. The gap could be eliminated by the self-correcting mechanism of the economy and eventually achieve long-run equilibrium at point ____ or the central bank could intervene with monetary easing and the long-run equilibrium would be at point ____.
A) recessionary; B; C
B) recessionary; C; B
C) expansionary; C; B
D) expansionary; B; C

Question

Based on the figure below, an economy in short-run equilibrium at point A has a(n) _______ gap. The gap could be eliminated by the self-correcting mechanism of the economy and eventually achieve long-run equilibrium at point ____ or the central bank could intervene with monetary easing and the long-run equilibrium would be at point ____. 
A) recessionary; B; C 
B) recessionary; C; B 
C) expansionary; C; B 
D) expansionary; B; C

Quizplus · Accepted Answer

Since the short-run equilibrium level of output is greater than the potential level of output, the economy is experiencing an expansionary output gap at point A. The self-correcting mechanism of the economy means that inflation will gradually start to increase in response to the expansionary gap - shifting the SRAS line upward. When inflation has risen enough, the economy is back in long-run equilibrium at point C. If instead the central bank intervenes with a tightening of monetary policy, shifting up its policy reaction function, aggregate demand will shift left from AD¹ to AD establishing the long-run equilibrium at point B where inflation remains at the lower level.

Based on the Figure Below, an Economy in Short-Run Equilibrium