Question

Suppose the Federal Reserve pursues contractionary monetary policy. In the long run
a. both inflation and the unemployment rate are higher than they were prior to the change in policy.

b. inflation is higher and the unemployment rate is the same as it was prior to the change in policy.

c. inflation is lower and the unemployment rate is lower than it was prior to the change in policy.
d. inflation is lower and unemployment is the same as it was prior to the change in policy.

The answer is D, but I do not understand why. Please explain, thank you.

Answer 1

The answer is D -) When the Fed pursues contractionary monetary policy , it will lead to decrease in the money supply and hence which will increase the interest rate and thus new investment will become costlier for new firms as a result , no new firms starts and people demand also decrease because income decreases. so the short run effect will be decrease in the aggregate demand result in decrease in inflation but in short run, unemployment also decreases but eventually in the long run, the economy adjust itself and back to its potential gdp and thus reach its full employment situation . therefore, inflation decrease but unemployment remain the same.