Question

If strong aggregate demand is pushing the economy beyond potential real GDP, which of the following must be true?

A) The economy is at an equilibrium that is on the long-run Phillips curve.
B) The economy is experiencing stagflation.
C) The economy is operating below its potential, leading to deflation.
D) The economy is operating beyond its capacity, leading to inflation.

Answer 1

If strong aggregate demand pushes the economy beyond potential real GDP, it signifies the economy is operating beyond capacity, leading to an increase in inflation, corresponding to answer D.

Step-by-step explanation:

If strong aggregate demand is pushing the economy beyond potential real GDP, it signifies that the economy is operating at full capacity and any additional increases in aggregate demand can only lead to an increase in price levels or inflation. This phenomenon is described by the aggregate demand/aggregate supply (AD/AS) framework, where inflationary pressures arise because additional aggregate demand when at or near potential real GDP will push the equilibrium to the AS curve's steep portion. The correct answer to the given question is D) The economy is operating beyond its capacity, leading to inflation.