If there is a temporary, significant increase in oil prices, what action can a central bank typically take regarding price level and real GDP?

When a central bank faces a temporary, significant increase in oil prices, it encounters a situation often referred to as a supply shock. Such a shock typically leads to higher production costs for businesses, which can result in inflation (an increase in the price level) and simultaneously reduce economic output (real GDP).

The central bank has the ability to influence economic conditions through monetary policy; however, the tools it utilizes—like adjusting interest rates—often have conflicting effects on price level and real GDP. For instance, if the central bank raises interest rates to combat inflation caused by rising oil prices, this could further dampen economic activity, leading to a reduction in real GDP. Conversely, lowering interest rates to spur economic growth could exacerbate inflation.

Given this trade-off, the central bank faces a challenge in trying to stabilize both the price level and real GDP at the same time during such shocks. As a result, it cannot effectively achieve both objectives simultaneously, making the answer that it cannot stabilize both the price level and real GDP correct. This situation highlights the inherent limitations of monetary policy, especially during instances of exogenous shocks like fluctuating oil prices.