If the Fed reduces the money supply by 5 percent, then the real interest rate will:
A) rise in both the short run and the long run.
B) rise in the short run but return to its original equilibrium level in the long run.
C) rise in the short run but will fall below its original equilibrium level in the long run.
D) be unaffected in both the short run and the long run.

Question

Quizplus · Accepted Answer

In the short run, reducing the money supply leads to a decrease in the money available for loans, which will increase borrowing costs and make it more expensive for firms to invest. This will cause the real interest rate to rise in the short run. However, in the long run, prices and wages will adjust to the lower money supply, causing a decrease in aggregate demand and a decrease in the price level. As the price level falls, the real interest rate will return to its original equilibrium level.

If the Fed Reduces the Money Supply by 5 Percent