Assume that the economy begins in long-run equilibrium. Then the Fed reduces the money supply. In the short run ______, whereas in the long run prices ______ and output returns to its original level.

Question

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When the Fed reduces the money supply, it causes a decrease in aggregate demand in the short run, leading to a decrease in output and no change in prices. However, in the long run, prices will adjust to the decreased aggregate demand, causing them to fall, and output will return to its original level. This is known as the long-run neutrality of money.

Assume That the Economy Begins in Long-Run Equilibrium