Suppose the economy is initially in long-run and short-run equilibrium. If the Fed decides to pursue a contractionary monetary policy, we will see

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Contractionary monetary policy, such as increasing the interest rates or reducing the money supply, leads to a decrease in aggregate demand as both investment and consumption spending decrease due to the higher cost of borrowing. This results in a decrease in real GDP and the price level in the short run. In the long run, the economy will adjust, and the price level will continue to fall, but real GDP will return to its natural level. Bond prices fall when interest rates rise as new bonds are issued at higher rates, and older bonds become less attractive, and hence their prices fall.

Suppose the Economy Is Initially in Long-Run and Short-Run Equilibrium