Suppose the economy is in full-employment equilibrium. Then a positive supply shock, caused by a fall in oil prices, hits the economy. An expansionary monetary policy will
A) stabilize prices with no effect on output.
B) stabilize prices but at a much higher output level in the short run.
C) move the economy back to full employment output but at a much higher price level.
D) move the economy back to full employment output but at a much lower price level.

Question

Quizplus · Accepted Answer

A positive supply shock, such as a fall in oil prices, leads to lower production costs, increased production, and lower prices. In the short run, expansionary monetary policy will increase aggregate demand and output, leading to higher prices. However, since the economy is in a full-employment equilibrium, the increase in output will not lead to long-term unemployment. Therefore, option B is correct since prices will eventually stabilize at a higher level, but output will also increase beyond full employment level in the short run. Option A is incorrect because output will increase due to the expansionary monetary policy. Option C is incorrect because the increase in prices will not necessarily return to the original equilibrium level. Option D is incorrect since the positive supply shock would lead to lower prices, not higher prices, in the short run.

Suppose the Economy Is in Full-Employment Equilibrium