Question

During $2017$ , some Fed officials discussed the possibility of increasing interest rates as a way of fighting potential increases in expected inflation. If the public came to expect higher inflation rates in the future, what would be the effect on the short-run aggregate supply curve? Use an aggregate demand and supply graph to illustrate your answer.

Short answer

The impact of higher projected inflation on the aggregate supply curve in the short run.

Step-by-step solution

Step 1. Concept of Inflation 

Inflation is defined as the rate at which the general price level of goods and services rises, resulting in a decline in the economy's purchasing power.

Step 2. Explanation

The following diagram depicts the impact of future expectations of high inflation on the short run aggregate supply curve:

1st Figure

If the public expects more inflation in the near future, the short-run aggregate demand curve will shift leftwards from AS to AS1. Because rising inflation leads to higher prices, producers are currently reducing aggregate supply in the economy in order to supply products and services at higher prices. In $2017$, Federal officials were on the verge of raising interest rates in order to keep inflation under control. An increase in interest rates is far too late; it will raise inflation expectations even more, but an increase in interest rates far too soon will stymie recovery. This will stifle recovery and may push the economy into recession.