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 towards 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 towards 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

If aggregate demand shifts right, this will cause an increase in output in the short-run above the long-run equilibrium level of output. The central bank, following the given rule, must decrease the money supply to counteract the rise in the price level caused by the increase in aggregate demand. This will cause a decrease in output back towards its long-run level. Therefore, the best choice is A.

Suppose That the Central Bank Must Follow a Rule That