Question

Suppose government spending increases. True or False: The effect on aggregate demand would be larger if the Federal Reserve held the money supply constant in response than if the Fed were committed to maintaining a fixed interest rate.

Answer 1

Answer:

False

Explanation:

When the government increases spending, aggregate demand increases. This leads to increase in demand of money.

If federal reserve holds money supply constant in this case, interest rate will increase. This will lead to 'crowding out' of private investment; & the total effect of government investment increase on AD is lesser.

If government keeps the interest rate constant, the private investment 'crowding out' effect will not occur. No private investment crowding out effect, & the total effect of government investment increase on AD is lesser.

So; The effect on aggregate demand would be lesser if the Federal Reserve held the money supply constant in response than if the Fed were committed to maintaining a fixed interest rate.