In the shorter run, inflation may rise and fall depending on where the economy is operating relative to its potential. When the economy has become overextended, with output exceeding the economy’s potential, employment beyond sustainable norms, and production surpassing normal capacity limits, then prices have tended to increase at an ever faster rate.
Likewise, when aggregate demand has fallen short of the economy’s potential, inflation has tended to fall. And this is where the short-run setting of monetary policy comes into play. By moving short-term interest rates, monetary policy can affect other financial conditions and end up exerting a substantial influence on aggregate demand.