Exhibit 14-5

-Refer to the graph in the exhibit.To bring the economy to its potential output level, what should the Bank of Canada do?
A) The Bank of Canada should do nothing, and the price level will fall to P′.
B) The Bank of Canada should do nothing, and the price level will remain at its current level.
C) The Bank of Canada should increase the money supply and decrease the price level to P′.
D) The Bank of Canada should decrease the money supply and decrease the price level to P′.

Question

Exhibit 14-5
 
-Refer to the graph in the exhibit.To bring the economy to its potential output level, what should the Bank of Canada do?  
A) The Bank of Canada should do nothing, and the price level will fall to P′. 
B) The Bank of Canada should do nothing, and the price level will remain at its current level. 
C) The Bank of Canada should increase the money supply and decrease the price level to P′. 
D) The Bank of Canada should decrease the money supply and decrease the price level to P′.

Quizplus · Accepted Answer

As the economy is operating above the potential output level, there is upward pressure on the price level. To bring the economy back to its potential output level, the Bank of Canada should decrease the money supply, which will lead to a decrease in aggregate demand and eventually decrease in the price level to reach P′. Choice A is incorrect as doing nothing will not bring the economy back to its potential output level. Choice B is incorrect as the economy will not automatically adjust to its potential output level without any intervention. Choice C is incorrect as increasing the money supply will only aggravate the upward pressure on the price level and further deviate the economy from its potential output level.

Exhibit 14-5 -Refer to the Graph in the Exhibit.To Bring the Economy