The figure given below depicts short-run equilibrium in an aggregate demand-aggregate supply model. If the economy is at point "e" in the short run, which of these policies adopted by the Fed is likely to return it to long-run equilibrium?

A) A decrease in government spending
B) An increase in the tax rate
C) A decrease in the tax rate
D) A decrease in the money supply
E) An increase in the money supply

Question

The figure given below depicts short-run equilibrium in an aggregate demand-aggregate supply model. If the economy is at point "e" in the short run, which of these policies adopted by the Fed is likely to return it to long-run equilibrium?

A) A decrease in government spending 
B) An increase in the tax rate 
C) A decrease in the tax rate 
D) A decrease in the money supply 
E) An increase in the money supply

Quizplus · Accepted Answer

Point "e" indicates an inflationary gap, where output is above potential output and the price level is higher than expected. Therefore, the Fed should implement a contractionary monetary policy to reduce aggregate demand and shift the AD curve leftward. This can be achieved through a decrease in the money supply, which will increase interest rates and reduce investment and consumption spending, eventually leading to a decrease in aggregate demand. This policy will return the economy to long-run equilibrium, where output is at potential output and the price level is stable. Options A and B are fiscal policies that are unlikely to have an immediate effect on aggregate demand, while options C and E are expansionary policies that will worsen the inflationary gap.

The Figure Given Below Depicts Short-Run Equilibrium in an Aggregate