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IAI Actuarial Core Principles · Business Economics · Business activity, unemployment and inflation

An economy's actual output is below its potential output, creating a negative output gap. Which combination of consequences is most likely, other things equal?

A negative output gap is likely to bring falling inflationary pressure and cyclical unemployment. Spare capacity means weak demand for labour and goods, so wage and price growth slows and unemployment rises above its natural rate, whereas the opposite occurs with a positive gap.

  1. ARising inflationary pressure and falling unemployment below the natural rate
  2. BFalling inflationary pressure and cyclical unemployment above zeroCorrect
  3. CRising inflationary pressure and rising cyclical unemployment
  4. DFalling inflationary pressure and unemployment below the natural rate
  5. No change in inflation or unemployment because potential output is unaffected

Explanation

With spare capacity, firms face weak demand, so wage and price pressures ease and cyclical unemployment arises as actual unemployment exceeds the natural rate. Rising inflation and unemployment below the natural rate belong to a positive output gap.

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