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, what must the central bank do, and what will happen to output?
A) The central bank must decrease the money supply, which will move output back toward its long-run level.
B) The central bank must decrease the money supply, which will move output farther from its long-run level.
C) The central bank must increase the money supply, which will move output back toward its long-run level.
D) The central bank must increase the money supply, which will move output farther from its long-run level.

Question

Quizplus · Accepted Answer

Since aggregate demand shifts right, there will be an excess demand for goods and services, causing the price level to rise above the long-run equilibrium level. According to the rule, the central bank must decrease the money supply to bring the price level back to its original level, which will move output back toward its long-run level. Therefore, option A is the correct choice.

Suppose That the Central Bank Must Follow a Rule That