Supply constraints limiting monetary policy

Steps:

• Decreasing interest rates reduces borrowing costs, stimulating investment and consumption to increase aggregate demand (AD).
• Rising AD boosts economic output and hiring, aiming to lower unemployment.
• If productive capacity is lacking, aggregate supply (AS) cannot expand to match higher AD.
• This results in inflationary pressures without real output or employment gains.

Why A is correct:

• In the AD-AS model, a lack of productive capacity shifts AD rightward but meets a vertical AS curve at full employment, raising prices without increasing real GDP or reducing unemployment.

Why the others are wrong:

• B: Excess demand boosts AD further, potentially aiding unemployment reduction if spare capacity exists.
• C: Increased government spending complements lower rates by raising AD, enhancing effectiveness.
• D: Low welfare benefits encourage workforce participation, supporting employment gains.

Final answer: A