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" represents a situation where the economy is producing output above the potential level of output. This implies that there is an inflationary gap, which is the difference between actual output and potential output. To return the economy to long-run equilibrium, the Fed needs to adopt contractionary monetary policy to reduce the level of aggregate demand in the economy.

Option D, which involves a decrease in the money supply, is the best choice for returning the economy to long-run equilibrium. By decreasing the money supply, the Fed can increase interest rates, which will reduce investment and consumption spending. This will lead to a decrease in aggregate demand, which will help to close the inflationary gap and return the economy to potential output in the long run.

Options A and B involve fiscal policy changes, which may not be effective in the short run, and may also have unintended consequences in the long run. Option C, which involves a decrease in the tax rate, would increase aggregate demand, worsening the inflationary gap. Option E, which involves an increase in the money supply, would also increase aggregate demand and worsen the inflationary gap. Therefore, the best choice for returning the economy to long-run equilibrium is D, a decrease in the money supply.

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