Which of the following is most likely to occur as a result of a decrease in the money supply in an economy?

• A. The value of the currency will depreciate in foreign exchange markets.
• B. Inflation will rise due to increased consumer demand.
• C. Interest rates will increase, leading to reduced investment and spending.
• D. Unemployment will decrease as businesses expand production.

Answer: (C)

Verified step by step guidance

1. Step 1: Understand the relationship between the money supply and interest rates. When the money supply decreases, there is less liquidity available in the economy, which tends to push interest rates up because borrowing money becomes more expensive.
2. Step 2: Recognize how higher interest rates affect investment and spending. Increased interest rates raise the cost of financing for businesses and consumers, which typically leads to a reduction in investment and consumption expenditures.
3. Step 3: Analyze the impact on inflation. A decrease in the money supply usually reduces inflationary pressures because there is less money chasing goods and services, so inflation is unlikely to rise due to increased consumer demand in this scenario.
4. Step 4: Consider the effect on the currency value. A decrease in the money supply often leads to an appreciation, not depreciation, of the currency in foreign exchange markets because higher interest rates attract foreign capital.
5. Step 5: Evaluate the impact on unemployment. Reduced investment and spending due to higher interest rates generally slow down economic activity, which can increase unemployment rather than decrease it.