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, given that supply-side effects dominate demand-side effects?
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 sharp rise in oil prices will increase the production cost for firms, shifting the short-run aggregate supply curve to the left, resulting in higher prices and lower output. Expansionary monetary and fiscal policies will increase aggregate demand, which can potentially offset the negative effects of the rise in oil prices. However, given that supply-side effects dominate, the result will be an increase in the price level and a decrease in real GDP. Therefore, the correct answer is D.

Suppose the Economy Is Initially in Long-Run Equilibrium