Question

Suppose that the central bank must follow a rule that requires it to increase the money supply when the price level falls and decrease the money supply when the price level rises. If the economy starts from long-run equilibrium and aggregate demand shifts right, the central bank must a. increase the money supply, which will move output back towards its long-run level. b. increase the money supply, which will move output farther from its long-run level. c. decrease the money supply, which will move output back towards its long-run level. d. decrease the money supply, which will move output farther from its long-run

Answer 1

Answer: Option (c) is correct.

Explanation:

Correct Option: Decrease the money supply, which will move output back towards its long-run level.

If the economy is in long run equilibrium and there is a rightward shift in the aggregate demand curve then as a result output and price level rises in an economy.

Here, the central must follow the contractionary monetary policy to stabilize the economy.

So, the central bank must decrease the money supply to move the output and price level back to its initial position.