Figure: Monetary Policy Reference: Ref 16-1 (Figure: Monetary Policy) Assume that the economy is initially at Point Y. In the best case scenario, the Fed will
A) increase money supply to take the economy to Point X.
B) decrease money supply to take the economy to Point W.
C) increase money supply to take the economy to Point W.
D) decrease money supply to take the economy to Point X.

Question

Figure: Monetary Policy  Reference: Ref 16-1 (Figure: Monetary Policy) Assume that the economy is initially at Point Y. In the best case scenario, the Fed will
A) increase money supply to take the economy to Point X. 
B) decrease money supply to take the economy to Point W. 
C) increase money supply to take the economy to Point W. 
D) decrease money supply to take the economy to Point X.

Quizplus · Accepted Answer

The best case scenario is when the economy is operating below its potential output (Point Y), indicating a recessionary gap. To close this gap and stimulate economic growth, the Fed should increase the money supply, which will lead to lower interest rates, increased investment, and increased aggregate demand. This expansionary monetary policy will shift the AD curve to the right, leading to output expansion and inflationary pressure. Point X represents the full-employment equilibrium after this policy shift.