Following a rapid tightening of monetary policy, the economy experienced a significant slowdown in early 2023, leaving a substantial output gap. This elevated level of spare capacity is expected to anchor inflationary pressures. With plenty of idle resources, manufacturers will find it difficult to pass cost increases onto consumers and may resort to discounting. Furthermore, workers' bargaining power is weakened, limiting wage-push inflation. This environment allows the central bank leeway to pause further interest rate hikes to support the fragile recovery. (Lines 1–5)
However, prolonged stagnation threatens long-run aggregate supply. Capital deep-freeze—where firms halt expansion plans, cancel R&D projects, and allow existing machinery to depreciate—will restrict future productive potential. Additionally, high long-term unemployment risks 'hysteresis', where deskilled workers permanently exit the workforce, permanently shrinking the labor supply. (Lines 6–10)
Extract D suggests that the 'elevated level of spare capacity is expected to anchor inflationary pressures'.
Explain two reasons why the existence of spare capacity in an economy is likely to help keep inflation low.
327 exam-style questions on AQA A Level Economics 2.3 Economic performance, covering 2.3.1 Economic growth and the economic cycle, 2.3.2 Employment and unemployment, 2.3.3 Inflation and deflation, and 2.3.4 Possible conflicts between macroeconomic policy objectives. Each one has a worked solution and a mark scheme showing where the marks go.