Question

The economy is in long-run equilibrium when there is an incorrectly anticipated increase in aggregate demand brought about by expansionary monetary policy. Specifically, aggregate demand increases by more than people anticipate (bias downward). According to new classical theory, the price level will __________ and Real GDP will __________ in the short run. In the long run, the price level will be __________ than it was before aggregate demand increased.

Select one:
a. rise; fall; higher
b. rise; rise; higher
c. fall; rise; lower
d. fall; rise; higher
e. rise; rise; lower

Answer 1

In the short run, both the price level and Real GDP will rise with an unexpected increase in aggregate demand. In the long run, price levels will be higher than before, reflecting inflation, but Real GDP will not be affected and return to its natural level. Therefore correct option is B

Step-by-step explanation:

According to new classical theory, when there is an incorrectly anticipated increase in aggregate demand due to expansionary monetary policy, the impact in the short run and long run differs. In the short run, an increase in aggregate demand more than anticipated will lead the price level to rise and Real GDP will also rise due to short-term adjustments.

However, in the long run, the economy will adjust such that Real GDP returns to its natural level due to the vertical Long-Run Aggregate Supply (LRAS) curve. As a result, the price level will be higher than it was before the aggregate demand increased, reflecting inflationary pressures, but Real GDP will remain unchanged at its potential level. Therefore, the correct answer to the question is (b) the price level will rise; Real GDP will rise; in the long run, the price level will be higher than it was before aggregate demand increased.