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In: Economics

In the AD-AS model, monetary policy cannot stabilize both the price level and the level of...

In the AD-AS model, monetary policy cannot stabilize both the price level and the level of real GDP following a shock to aggregate supply

True or False? Would appreciate a detailed explanation. Thanks!

Solutions

Expert Solution

The given statement is True.

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Explanation:

When a shock to AS takes place, the AS curve shifts.

Suppose a negative shock affects AS, shifting it to the left. This raises the price level, and lowers the GDP level.

Monetary policy will affect the AD curve, and not the AS curve. To correct the effect of the negative AS shock, expansionary monetary policy will shift AD to the right. Due to this, real GDP will be restored, but price level will be higher than even before.

On the other hand, if prices are attempted to be restored, this can be done by contractionary monetary policy. This will shift AD to the left. This will cause prices to come down (after the negative AS shock), but real GDP will be much lower than before.

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Therefore, there exists a trade-off: to bring back the economy's real GDP level, AD curve will have to be shifted to the right, thus causing a further increase in the price level. On the other hand, to maintain price level, AD will have to be shifted to the left, but real GDP will fall.

Thus, both price level and real GDP cannot be stabilized at the same time.

Rahul Sunny answered 2 years ago
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