Suppose the Economy Is Initially Operating at the Potential Level

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The Answer is The reduction in the money supply will cause a reduction in aggregate demand. This causes the AD curve to shift left. As AD falls, firms cut production and the price level falls. Over time, wages will be reduced and the short-run aggregate supply curve shifts right. As it does this, the price level continues to fall and output will now increase. In the long run, output returns to the potential level of output and the price is lower. The economy moves from point E0 to E1.

The reduction in the money supply will cause a reduction in aggregate demand. This causes the AD curve to shift left. As AD falls, firms cut production and the price level falls. Over time, wages will be reduced and the short-run aggregate supply curve shifts right. As it does this, the price level continues to fall and output will now increase. In the long run, output returns to the potential level of output and the price is lower. The economy moves from point E0 to E1.

Suppose the Economy Is Initially Operating at the Potential Level

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