Consider the following statement from an advisor to the Federal Reserve: \"The i
ID: 1122160 • Letter: C
Question
Consider the following statement from an advisor to the Federal Reserve: "The increase in the stock market has increased people's wealth. As a result, their consumption has increased, increasing aggregate demand and output. So the Fed needs to increase the money supply, since with higher income, people's demand for real money balances will be higher." Suppose the Fed follows this advice and increases money supply. Using the IS-LM model we can conclude that this action by the Fed will:
A help the economy complete the price adjustment faster
B generate more inflation
C generate less inflation
D help keeping the interest rate at the initial level.
Explain your answer.
Explanation / Answer
Correct option is (B).
Increase in money supply will lower interest rate, which will boost consumption investment demand, therefore further increasing aggregate demand, which will increase price level further. Inflation will be higher than before.