If the economy is at potential output and the Fed increases the money supply, in the short run, what happens to investment and consumer spending?

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Prepare for the Rutgers Macroeconomics Test with multiple choice questions, hints, and explanations. Master key concepts and excel in your exam!

Multiple Choice

If the economy is at potential output and the Fed increases the money supply, in the short run, what happens to investment and consumer spending?

Explanation:
When the Fed increases the money supply, it lowers real interest rates in the short run because more money is chasing the same borrowers. Cheaper credit makes households more willing to borrow for big purchases and durable goods, boosting consumer spending. It also makes it cheaper for firms to finance new projects, raising investment. Since the economy is at potential output, this higher demand tends to push up prices rather than produce a big sustained rise in real GDP, but the immediate effect on spending is that both investment and consumer spending increase.

When the Fed increases the money supply, it lowers real interest rates in the short run because more money is chasing the same borrowers. Cheaper credit makes households more willing to borrow for big purchases and durable goods, boosting consumer spending. It also makes it cheaper for firms to finance new projects, raising investment. Since the economy is at potential output, this higher demand tends to push up prices rather than produce a big sustained rise in real GDP, but the immediate effect on spending is that both investment and consumer spending increase.

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