The figure given below depicts short-run equilibrium in an aggregate demand-aggregate supply model. The Fed can return the economy to potential output in the long run by:

A) purchasing U.S. government securities.
B) decreasing taxes.
C) selling U.S. government securities.
D) lowering the discount rate.
E) lowering the required reserve ratio.

Question

The figure given below depicts short-run equilibrium in an aggregate demand-aggregate supply model. The Fed can return the economy to potential output in the long run by:

A) purchasing U.S. government securities. 
B) decreasing taxes. 
C) selling U.S. government securities. 
D) lowering the discount rate. 
E) lowering the required reserve ratio.

Quizplus · Accepted Answer

In the short-run equilibrium depicted in the figure, the economy is operating above its potential output level (Yp) with high inflation. To return the economy to Yp in the long run, the Fed should decrease aggregate demand, which can be achieved by selling U.S. government securities in the open market, reducing the amount of reserves in the banking system, and ultimately decreasing the money supply. This will shift the aggregate demand curve to the left, leading to a decrease in both output and prices, eventually returning the economy to its potential output level without high inflation. Therefore, option C is the best choice.

Note: Options A, B, D, and E are all expansionary monetary policies, which will further increase aggregate demand and exacerbate the inflation problem, making them inappropriate choices for this situation.

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