If decision makers fail to anticipate the inflationary effects of demand stimulus policies, in the short run the stimulus will
Click on the arrows to vote for the correct answer
A. B. C. D. E.Explanation
Unanticipated inflation, as the result of demand stimulus policies, increases output and employment since the real wage is eroded and the cost of labor declines.
The correct answer is A. increase both inflation and the nominal interest rate but exert little impact on real output and employment.
Demand stimulus policies, such as increasing government spending or reducing taxes, are designed to boost economic activity and stimulate aggregate demand. In the short run, these policies can have both intended and unintended effects on the economy.
When decision makers fail to anticipate the inflationary effects of demand stimulus policies, it means they do not foresee that these policies could lead to an increase in the overall price level, commonly known as inflation.
In the short run, the stimulus is likely to increase both inflation and the nominal interest rate. Here's why:
Increase in inflation: When demand is stimulated, consumers and businesses tend to spend more, increasing the demand for goods and services. As demand outpaces supply, producers may respond by raising prices. This increase in prices leads to inflation, eroding the purchasing power of money.
Increase in the nominal interest rate: The nominal interest rate is the rate of interest before accounting for inflation. When inflation is anticipated or observed to be rising, lenders and investors will demand higher nominal interest rates to compensate for the expected loss in purchasing power caused by inflation. Therefore, failing to anticipate inflationary effects would result in an increase in the nominal interest rate.
However, the short-run impact on real output and employment is expected to be limited. This is because the increase in demand, driven by the stimulus, may be absorbed by existing production capacity and resources. In other words, there may not be enough spare capacity in the economy to significantly increase output and employment levels in the short run. As a result, the stimulus is not expected to have a substantial impact on real output (the actual production of goods and services) and employment (the number of people employed).
In summary, when decision makers fail to anticipate the inflationary effects of demand stimulus policies, the short-run outcome is likely to be an increase in both inflation and the nominal interest rate, while real output and employment remain relatively unaffected.