Question

use the graph to answer the question.
country x’s economic situation is depicted by the graph above. which of the following will happen if country x’s central bank conducts a contractionary monetary policy?
a the economy will be in a recessionary gap; the price level will decrease, and the real output level will increase.
b the economy will be in a recessionary gap; the price level and the real output level will decrease.
c the economy will be at full employment; the price level and the real output level will increase

Explanation:

1. Initial state: The graph shows AD, SRAS, and LRAS intersecting at the same point, meaning the economy is initially at full employment (real GDP equals potential GDP).
2. Contractionary monetary policy: This policy (e.g., raising interest rates, reducing money supply) reduces aggregate demand, shifting the AD curve leftward.
3. New equilibrium: The left-shifted AD curve will intersect SRAS at a point to the left of LRAS. This creates a recessionary gap (real GDP < potential GDP). At this new equilibrium, both the price level and real output level are lower than the initial full-employment levels.
4. Option analysis:

• A is incorrect because real output decreases, not increases.
• B matches the outcomes of contractionary monetary policy in this scenario.
• C is incorrect because contractionary policy reduces, not increases, price and output, and moves the economy away from full employment.

Answer:

B. The economy will be in a recessionary gap; the price level and the real output level will decrease.