If U.S. inflation increases to 5% while European inflation remains at 3%, what is likely to happen?

When U.S. inflation rises to 5% while European inflation holds steady at 3%, the purchasing power of consumers in the U.S. diminishes relative to their counterparts in Europe. Higher inflation in the U.S. means that prices for goods and services there are increasing more quickly than in Europe, making domestic goods more expensive for consumers.

As a result, consumers are likely to seek alternatives to U.S. goods that are now relatively pricier. This shift in behavior increases demand for European goods, which are still available at a lower inflation rate, making them relatively more attractive in terms of price and value. Therefore, with U.S. consumers responding to higher prices domestically, the demand for European goods can increase due to their more stable pricing in comparison.

This understanding of consumer behavior in response to differing inflation rates highlights why the correct answer indicates an increased demand for European goods.