When the economy of a country is operating close to its full capacity, which of the following is most likely to occur?

• A. Aggregate demand falls below aggregate supply
• B. The central bank lowers interest rates to stimulate growth
• C. Inflationary pressures tend to increase
• D. Unemployment rates rise sharply

Answer: (C)

Verified step by step guidance

1. Step 1: Understand the concept of 'full capacity' in an economy, which means the economy is producing at or near its maximum sustainable output level, often referred to as potential GDP.
2. Step 2: Recognize that when an economy is at full capacity, resources such as labor and capital are fully employed, so output cannot easily increase without causing upward pressure on prices.
3. Step 3: Analyze the relationship between aggregate demand (AD) and aggregate supply (AS) in this context. If aggregate demand increases beyond full capacity, it leads to demand-pull inflation because supply cannot keep up.
4. Step 4: Consider the implications of aggregate demand falling below aggregate supply or unemployment rising sharply; these scenarios typically occur when the economy is below full capacity, not at or near it.
5. Step 5: Conclude that when the economy is operating close to full capacity, inflationary pressures tend to increase because demand outstrips the economy's ability to produce more goods and services without raising prices.