Question

Suppose that the monetary expansion is expected. In this case, the economy will follow which of the following paths?

A) AD1 increases to AD2, then SRAS1 decreases to SRAS2.
B) AD1 increases to AD2 at the same time as SRAS1 decreases to SRAS2.
C) SRAS1 increases to SRAS2, then AD1 increases to AD2.
D) AD2 decreases to AD1, then SRAS2 increases to SRAS1.

Answer 1

The correct path the economy would follow if a monetary expansion is expected is B) AD1 increases to AD2 at the same time as SRAS1 decreases to SRAS2, due to immediate adjustment of expectations and wages with rational expectations.

Step-by-step explanation:

If we suppose that a monetary expansion is expected, the players in the economy such as workers and firms adjust their expectations accordingly. In economic terms, if individuals have rational expectations, they would anticipate the effects of expansionary monetary policy and adjust their wage demands preemptively, leading to an immediate shift in the short-run aggregate supply (SRAS).

Thus, the response to the expected monetary expansion would follow this path: Aggregate Demand (AD) increases from AD1 to AD2, and as individuals adjust their expectations and wages, Short-Run Aggregate Supply (SRAS) shifts from SRAS1 to SRAS2 virtually simultaneously. Therefore, the correct answer to the question is B) AD1 increases to AD2 at the same time as SRAS1 decreases to SRAS2.