If the Federal Reserve decreased the money supply, which of the following is most likely to occur in the short run?

• A. Interest rates would fall, leading to an increase in aggregate demand.
• B. Aggregate demand would increase due to higher consumer spending.
• C. The price level would immediately rise as a result of increased money supply.
• D. Interest rates would rise, leading to a decrease in aggregate demand.

Answer: (D)

Verified step by step guidance

1. Understand the relationship between the money supply and interest rates: When the Federal Reserve decreases the money supply, there is less money available in the economy for borrowing and spending.
2. Recall the liquidity preference theory, which states that a decrease in money supply leads to higher interest rates because money becomes scarcer and more expensive to borrow.
3. Analyze how higher interest rates affect aggregate demand: Higher interest rates increase the cost of borrowing for consumers and businesses, which tends to reduce consumption and investment spending.
4. Connect the decrease in consumption and investment to aggregate demand: Since aggregate demand is the total demand for goods and services in the economy, a reduction in spending causes aggregate demand to decrease.
5. Summarize the short-run effect: A decrease in the money supply leads to higher interest rates, which then causes aggregate demand to fall, rather than rise.