What is the most likely short-run effect of an increase in the money supply in an economy?

• A. Decreased price level and reduced output
• B. Higher unemployment and decreased aggregate demand
• C. Higher interest rates and reduced investment
• D. Lower interest rates and increased aggregate demand

Answer: (D)

Verified step by step guidance

1. Step 1: Understand the role of the money supply in the economy. An increase in the money supply means there is more money available for households and firms to hold and spend.
2. Step 2: Recall the liquidity preference theory, which states that an increase in the money supply lowers the interest rate because there is more money available relative to the demand for money.
3. Step 3: Recognize that lower interest rates reduce the cost of borrowing, encouraging businesses and consumers to increase investment and consumption.
4. Step 4: Connect the increase in investment and consumption to a rise in aggregate demand, as these components are part of aggregate demand in the economy.
5. Step 5: Conclude that in the short run, an increase in the money supply leads to lower interest rates and increased aggregate demand, which typically results in higher output and price levels.