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,the central bank must
A)decrease the money supply,which shifts aggregate demand further right.
B)decrease the money supply,which shifts aggregate demand left.
C)increase the money supply,which shifts aggregate demand further right.
D)increase the money supply,which shifts aggregate demand left.

Question

Quizplus · Accepted Answer

If the economy starts from long-run equilibrium and aggregate demand shifts right, it will cause an inflationary gap (output above potential output) in the short run. Since the central bank must follow a rule that requires it to decrease the money supply when the price level rises, it will decrease the money supply in response to the increase in aggregate demand. This will shift the aggregate demand curve leftward, reducing output and inflation in the short run, bringing the economy back to long-run equilibrium. Therefore, the correct answer is B, decrease the money supply, which shifts aggregate demand left.

Suppose That the Central Bank Must Follow a Rule That