Multiple Choice
In the context of a severe recession, which monetary policy action should the Federal Reserve take to stimulate aggregate demand?
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18. Monetary Policy
Monetary Policy and Aggregate Demand
Multiple Choice
If the Federal Reserve decreased the money supply, which of the following is most likely to occur in the short run?
A
Interest rates would fall, leading to an increase in aggregate demand.
B
Aggregate demand would increase due to higher consumer spending.
C
The price level would immediately rise as a result of increased money supply.
D
Interest rates would rise, leading to a decrease in aggregate demand.
Verified step by step guidance1
Understand the relationship between the money supply and interest rates: When the Federal Reserve decreases the money supply, there is less money available in the economy for borrowing and spending.
Recall the liquidity preference theory, which states that a decrease in money supply leads to higher interest rates because money becomes scarcer and more expensive to borrow.
Analyze how higher interest rates affect aggregate demand: Higher interest rates increase the cost of borrowing for consumers and businesses, which tends to reduce consumption and investment spending.
Connect the decrease in consumption and investment to aggregate demand: Since aggregate demand is the total demand for goods and services in the economy, a reduction in spending causes aggregate demand to decrease.
Summarize the short-run effect: A decrease in the money supply leads to higher interest rates, which then causes aggregate demand to fall, rather than rise.
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