Question

To counteract a positive demand shock, the Fed uses ________________ monetary policy, which ________________ .

contractionary; reduces output and increases the price level

contractionary; reduces both output and the price level

expansionary; increases both output and the price level

expansionary; reduces output and increases the price level

Answer 1

Positive demand shock is basically the situation when the aggregate demand for goods and services in the economy goes up because people starts demanding more of them. As a result of this increased demand, prices of good and services in the economy goes up. In other words, the economy experiences an inflation.

Now, the job of the Fed is to keep the economy balanced and minimise the cyclical fluctuations in the economy (inflation and deflation). So it will undertake countercyclical policies to combat these (policies which aims to combat the cyclical fluctuations).

So, the idea is to decrease the aggregate demand in the country. In order to do that, Fed will use contractionary monetary policy (i.e. reduce the money supply in the economy by increasing the interest rates and so on). This will reduce the overall demand of goods and services (aggregate demand). When the overall demand falls, the price level will naturally fall as well.

Hence,

To counteract a positive demand shock, the Fed uses contractionary monetary policy, which reduces both output and price level.