FIGURE 27-5 Refer to Figure 27-5.This economy begins in equilibrium with M_S⁰,M_D⁰ and real GDP equal to potential GDP (with and ).Now suppose there is an increase in the money supply to $540 billion.After the initial effect on the interest rate,the next response in this economy is as follows:

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An increase in the money supply causes a lower interest rate, which stimulates investment demand and causes the AD curve to shift to the right. This leads to an increase in real GDP to $805 billion and a rise in the price level to 102. Option B is incorrect because a lower interest rate would not increase the demand for money. Option C and D are incorrect because a lower interest rate would not cause factor prices to rise; instead, it would lead to an increase in aggregate demand and a rise in output and prices.