Why is monetary policy not fully effective in combating a negative supply shock?
a) the Fed has no tools with which to stimulate an economy after the Solow growth curve shifts to the left
b) When countering a negative supply shock, Fed action will cause deflation
c) when countering a negative supply shock, Fed action will raise unemployment
d) When countering a negative supply shock, Fed action will raise inflation
Of these options, the best choice is D. If the Fed takes actions that are strong enough to completely make up for the supply shock, it is likely to cause inflation.
When a supply shock occurs, there is likely to be both an increase in the price level and a decrease in real GDP. The Fed will want to act to move GDP back up. In the 1970s, the Fed acted to reduce the price level and this made the drop in GDP worse than it would have been if the supply shock (caused by oil prices) had been the only problem. Today, the Fed would be more interested in getting real GDP back up.
The problem is that the tools the Fed would use to do this can also increase the price level. What the Fed would typically do to combat low RGDP would be to increase the money supply. But increasing the money supply also makes an increase in inflation more likely. Therefore, the Fed’s response to a supply shock might end up raising the rate of inflation. This means D is the best answer.