Question

Suppose the economy is producing at potential GDP. An increase in consumer and business confidence will cause ________ in real GDP in the short run and ________ in inflation in the short run, everything else held constant.

Answer 1

Answer:

An increase in consumer and business confidence will cause an increase in real GDP in the short run and no change in inflation in the short run, everything else held constant.

Explanation:

Please refer attached diagram while reading the explanation :) This will make it easier to understand...

Real GDP (Gross Domestic Product) is the value of all goods and services produced by an economy in a given period of time. When there is an increase in consumer confidence, it is likely that they will spend and purchase more in the economy. This in turn means that the aggregate demand curve will shift to the right (from AD1 to AD2).

On the other hand, when business confidence increase, it is likely that they believe they have a greater growth, profitability and survival in the economy. Hence, they will increase production. This in turn means, the aggregate supply curve will shift right as well (from AS1 to AS2).

Originally, the economy operated at PL1 and AS1/AD1  (market equilibrium point A). With the change in business and consumer confidence causing the right-hand shifts in the curves, the new market equilibrium (B) determines an increase in real GDP to AS2/AD2. However, the price level remains at PL1 which determines that it remains constant and hence there is neither a decrease nor increase in inflation in the short run.