Question

Assume firms become more pessimistic about the future and respond by decreasing investment spending. The Aggregate Demand/Aggregate Supply model suggests that if the Federal Reserve wishes to offset the short run consequences of the decrease in investment it should

Group of answer choices

Decrease the money supply in order to increase interest rates.

Increase the money supply in order to increase interest rates.

Decrease the money supply in order to decrease interest rates.

Increase the money supply in order to decrease interest rates.

Answer 1

As firms become more pessimistic about the future and respond by decreasing investment, this will result in decrease in aggregate demand(AD) and thus AD curve will shift to the left.

Now in order to offset this Federal reserve should change money supply in such a way that will result in rightward shift of AD curve(or increase in aggregate demand).

So, Federal reserve should increase money supply because increase in money supply will shift Money supply curve and LM curve to the right which will result in decrease in interest rate. As investment is inversely related to interest rate. This decrease in interest rate will result in increase in investment an any given price level and thus aggregate demand will increase and AD curve will shift to the right and hence will offset this short run consequence. Thus oprion (d) is the correct answer and rest all are incorrect.

Hence, the correct answer is (d) Increase the money supply in order to decrease interest rates.