Question

How is inflation, the output gap and monetary policy related?

Answer 1

Monetary policy has a significant influence on inflation. For instance, when the federal funds rate is lowered, it results to a higher demand of goods and services hence pushing other costs and wages higher, reflecting the higher demand for workers and materials that are necessary for production.

On the other hand, a positive output gap commonly spurs inflation in an economy because both labour costs and prices of goods increase as a result of increased demand.