Which pair correctly describes the short-run effect when monetary policy expands while the economy is at potential output?

• A. Decrease in investment; decrease in consumer spending
• B. Increase in investment; decrease in consumer spending
• C. Decrease in investment; increase in consumer spending
• D. Increase in investment; increase in consumer spending

Answer: (B)

When monetary policy expands, the central bank increases the money supply, which lowers short-term interest rates. Lower borrowing costs make it cheaper for firms to finance new capital, so investment tends to rise. That direct, highly interest-sensitive channel is the main short-run impact on the components of demand: investment goes up.

Consumption, by contrast, is less directly tied to short-term interest rates when the economy is already at potential output. In some short-run scenarios, households may time their spending differently in response to the policy, or the rise in the price level that can accompany the expansion (even if output doesn’t rise right away) can crowd out some current consumption as real purchasing power shifts. In this framing, consumption might fall or not rise as much as investment.

So the short-run pattern described here—investment increasing while consumer spending decreases—fits the idea that investment responds more strongly to lower borrowing costs, whereas consumption can dip due to the slower or offsetting effects on households’ real purchasing power or saving behavior at full output.