If the economy is at potential output and a negative supply shock is accommodated by an open market purchase, what happens to real GDP and inflation in the long run?

• A. No change; a decrease
• B. An increase; an increase
• C. No change; an increase
• D. A decrease; a decrease

Answer: (C)

When the economy is at potential output, the long-run level of real GDP is determined by the economy’s productive capacity, not by monetary policy. A negative supply shock moves SRAS left, pushing prices up and real GDP down in the short run. If the central bank offsets this with an open-market purchase (expansionary policy), aggregate demand rises and the short-run contraction is mitigated, with real GDP moving back toward potential. But as prices and wages adjust, real GDP returns to potential in the long run, while the higher price level from the shock and the expansionary policy leaves inflation elevated. So real GDP ends up unchanged at potential, and inflation increases.