Final answer:
Tightening of monetary policy initially leads to decreased output due to lower money supply and higher interest rates, followed by a recovery after the economy adjusts.
Step-by-step explanation:
In response to an unanticipated tightening of monetary policy, output decreases at first, then increases after about 4 months. This is because tight monetary policy initially reduces the quantity of money and credit, leading to higher interest rates and a subsequent decline in borrowing and spending.According to the principles of contractionary monetary policy, the central bank is attempting to hold down inflation by reducing the money supply and credit availability.
This causes a shift of aggregate demand to the left, leading to a temporary decline in output, or real GDP. However, the economy adjusts over time, and output tends to normalize or increase as the initial shocks dissipate and the market adapts to the new conditions.When there is an unanticipated tightening of monetary policy, it leads to a decrease in output at first. This is because higher interest rates associated with tight monetary policy make borrowing more expensive, which reduces investment and consumption. However, after about 4 months, the effects of the tightening policy start to take effect, causing output to increase. This is because the decrease in aggregate demand leads to a decrease in prices, making borrowing and investment more attractive, ultimately boosting economic activity and output.