Final answer:
Monetary policy can help in restoring the economy to its pre-recession conditions by being countercyclical. Expansionary policy reduces interest rates to boost spending and aggregate demand, while contractionary policy increases rates to curb inflation. Proper calibration is key to avoid overreaction and undesirable economic effects.
Step-by-step explanation:
When supply shifts cause a downturn in the economy, monetary policy can play a crucial role in restoring the economy to its pre-recession conditions. Expansionary monetary policy, which involves reducing interest rates, can stimulate investment and consumption spending. This increases aggregate demand, shifting it to the right from AD to AD₁, potentially moving the economy back to potential GDP.as illustrated in Figure 6(a). Conversely, contractionary monetary policy is used to counteract inflationary pressures by increasing interest rates and shifting aggregate demand to the left, moving the economy towards potential GDP, as shown in Figures 28.8(b) and 6(b).
Monetary policy, therefore, should be countercyclical, responding appropriately to the business cycle to manage both inflation and unemployment. However, it is essential to avoid overreaction to prevent triggering the opposite of the intended effect, such as inflation in the case of overly expansive policies or a recession in case of overly contractionary policies, summarized in Figures 28.9(a) and 15.9(a).
The statement that "monetary policy is absolutely ineffective, in the short-run" is not accurate, as it can indeed impact the economy in the short-run. Additionally, the claim that "the natural rate of unemployment decreases" as a result of a downturn caused by supply shifts is misleading because the natural rate of unemployment is determined by real economic factors and not merely the current state of the economy.