Question

Conversely, if an economy is producing at a quantity of output above its potential GDP, a contractionary monetary policy can reduce the inflationary pressures for a rising price level.

(True/False)

Answer 1

True, contractionary monetary policy can mitigate inflationary pressures when an economy produces above its potential GDP by shifting the aggregate demand curve left, leading to reduced output and a new equilibrium at the potential GDP level.

Step-by-step explanation:

True. When an economy is producing above its potential GDP, it often triggers inflationary pressures due to demand outstripping supply. Contractionary monetary policy can be used as a tool to mitigate these pressures. By reducing aggregate demand, a contractionary policy raises interest rates, which in turn discourages borrowing and spending. The subsequent shift of the aggregate demand curve (AD) to the left leads to a new equilibrium where output is reduced to the potential GDP level, thus alleviating inflationary pressures.

As detailed in several figures such as Figure 28.8 and Figure 15.8, when the original equilibrium (Eo) occurs at an output level above potential GDP, the implementation of a contractionary monetary policy causes the demand curve to shift from AD to AD₁. Consequently, the new equilibrium (E₁) is established at the potential GDP level of 700, as opposed to the excessive level of 750. This process helps the economy stabilize at a sustainable growth rate without excessive inflation.