In the above figure, is the Fed likely to be afraid that inflation will occur or that a recession will occur? Discuss the appropriate monetary policy that should be made to restore the economy to potential GDP

What will be an ideal response?

The Fed will fear inflation. The economy is in a short-run equilibrium with real GDP of $13.5 trillion, which exceeds potential GDP of $13.0 trillion. If the Fed does nothing, the aggregate supply curve will begin to shift leftward, raising the price level and creating inflation as it moves the economy back to potential GDP. In order to limit the inflation, the Fed needs to raise the federal funds rate, thereby decreasing aggregate demand.