Suppose that households and businesses increase autonomous expenditures, driving output well above potential. Describe, in detail, how monetary policy might react to minimize the increase in inflation

What will be an ideal response?

A positive output gap puts upward pressure on wages and other input prices, so prices and inflation rise. Rising inflation induces an automatic monetary policy response to increase the real interest rate; the increase in expenditure and output is muted by the response of expenditures to the higher real interest rate. If there is no autonomous monetary policy, the increase in inflation will cause an updating of expected inflation, shifting the aggregate supply curve up. Even thought the output gap is now shrinking, inflation continues to rise as workers press for nominal wage increases to compensate for inflation (recent, current, and anticipated). An autonomous monetary policy response can short-circuit the expectations driven shifting of the aggregate supply curve by increasing the speed and size of the increase in the real interest rate (the aggregate demand curve shifts to the left). If it is widely believed that the central bank will not tolerate an increase in the inflation rate, then the aggregate supply curve might not shift at all, and the economy will return to potential output and to the original rate of inflation.