Final answer:
Expansionary monetary policy most effectively increases real output when the economy is operating below its potential GDP. It shifts the aggregate demand curve to the right, stimulating growth, but once potential GDP is reached, further expansionary efforts mainly cause inflation.
Step-by-step explanation:
An expansionary monetary policy is more likely to increase real output more than just temporarily when the economy is operating at less than full capacity. If the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP. For instance, if an economy is in a state where the actual output is at 600 and the potential GDP is 700, expansionary policy will reduce interest rates, which stimulates investment and consumer spending, and in turn, shifts the aggregate demand curve (AD) to the right from AD to AD₁, leading to a new equilibrium (E₁) at the level of potential GDP.
However, once potential output is reached, further expansionary policy would predominantly cause inflation rather than a significant increase in real output. This is because after reaching the potential GDP, the economy's capacity to produce goods and services without generating inflation is limited, and pushing beyond this limit with expansionary measures will result in increased prices rather than a substantial growth in real output.