Suppose the economy is initially in long-run equilibrium. Now suppose oil prices rise sharply and at the same time, policymakers pursue expansionary monetary and fiscal policies. Which of the following will occur as a result of these two events?
A) The price level will necessarily rise but the effect on output is indeterminate.
B) Real GDP must necessarily fall but the effect on the price level is indeterminate.
C) The price level and real GDP must rise.
D) The price level must rise and real GDP must fall.

Question

Quizplus · Accepted Answer

The combination of a supply shock (rise in oil prices) and expansionary policies can have conflicting effects on the economy. The increase in oil prices will shift the short-run aggregate supply (SRAS) curve to the left, causing both output and prices to rise. However, the expansionary policies will shift the aggregate demand (AD) curve to the right, causing output and prices to rise further. The net effect on output depends on the magnitudes of the two effects - it could either increase, decrease, or stay the same. However, the price level will necessarily rise due to the oil shock. Hence, option A is the correct answer.

Suppose the Economy Is Initially in Long-Run Equilibrium