Suppose there was a large increase in net exports. If the Federal Reserve wanted to stabilize output, it could:

• A. Decrease the money supply to raise interest rates
• B. Increase the money supply to lower interest rates
• C. Reduce government spending
• D. Keep the money supply unchanged

Answer: (A)

Verified step by step guidance

1. Step 1: Understand the effect of a large increase in net exports on the economy. An increase in net exports raises aggregate demand, which tends to increase output and income in the short run.
2. Step 2: Recognize that the Federal Reserve can influence output by adjusting the money supply, which affects interest rates. Increasing the money supply lowers interest rates, stimulating investment and aggregate demand, while decreasing the money supply raises interest rates, reducing investment and aggregate demand.
3. Step 3: Since net exports have increased aggregate demand and output, the Fed aiming to stabilize output would want to offset this increase to prevent overheating or inflationary pressure.
4. Step 4: To offset the increase in output caused by higher net exports, the Fed should decrease the money supply. This action raises interest rates, which dampens investment and aggregate demand, helping to stabilize output.
5. Step 5: Conclude that the correct policy action for the Fed to stabilize output after a large increase in net exports is to decrease the money supply to raise interest rates.