Question

(Figure: Monetary Policy and Demand Shocks) Refer to the figure. In the figure, assumethe initital real growth rate of the economy is 3% when a positive aggregate demand shock shifts the AD curve from AD1 ro AD4. As a result of the Fed's policy response, the AD curve shifts to AD3 in the short run. Which of the following is TRUE about the Fed's policy response?

Answer 1

In the case of positive aggregate demand shock in the economy, there is inflationary gap in the economy and actual output exceeds the potential level of output in the economy. In order to eliminate the inflationary gap in the economy, the Fed should reduce the level of money supplied in the economy either by selling government securities or increasing interest rate in the economy. This is the reason that had shifted the aggregate demand curve of the economy leftwards.