Question

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 so interest rates rise.
b) increase the money supply so interest rates fall.
c) decrease the money supply do interest rates fall
d) increase the money supply so interest rates rise.

Answer 1

Answer:

A). Decrease the money supply so interest rates rise.

Explanation:

This could be explained simply because change in money supply results in changes in price levels and/or a change in supply of goods and services. An increase in money supply results in a decrease in the value of money because an increase in money supply causes a rise in inflation. As inflation rises, the purchasing power, or the value of money, decreases.

A change in interest rates is one way to make that correspondence happen. A fall in interest rates increases the amount of money people wish to hold, while a rise in interest rates decreases that amount. A change in prices is another way to make the money supply equal the amount demanded.

Answer 2

Answer:

Explanation:

Aggregate demand is the total demand for a commodity in an economy. In this case it is demand for money.

As illustrated bin the attached diagram, when there is a shift of aggregate demand to the right there will be an increase in price and equillibrum quantity increases.

When price increases the central bank will increase money supply.

As a result of excess money in the economy the cost of borrowing money (interest) will reduce.

This is because money is now readily available, so borrowers will be willing to pay less interest.