The dilemma facing the Federal Reserve in the event that an unfavorable supply shock moves the economy away from the natural rate of output is that monetary policy can either return output to the natural rate, but with a ______ price level, or allow the price level to return to its original level, but with a ______ level of output in the short run.
A) higher; higher
B) higher; lower
C) lower; lower
D) lower; higher

Question

Quizplus · Accepted Answer

If an unfavorable supply shock moves the economy away from the natural rate of output, the Federal Reserve can either use contractionary monetary policy to reduce inflationary pressure and return output to the natural rate, but this will lead to a higher price level in the short run. Alternatively, the Fed could allow the price level to adjust back to its original level but this would result in a lower level of output in the short run. The best choice is B because while a higher price level could be undesirable, it is generally easier and faster to bring down inflation than to raise output back to the natural rate. A lower level of output can have significant negative consequences, such as increased unemployment and reduced economic growth.

The Dilemma Facing the Federal Reserve in the Event That