Answer:
In the long run, the decrease in the money supply will cause the price level in the economy to ___decrease___ and real GDP to ___remain unchanged___.
Explanation:
Decrease in money supply decreases aggregate demand leading to decrease in real GDP. In the long run, nominal wages will fall, leading to increase in aggregate supply. This results in further decrease in price level and increase in real GDP to its initial level.
The sale of government securities by the Fed reduces the level of reserves in the banking system, thus decreasing the money supply. Since people will hold less money than they desire for purchases, their spending will decline. As a result, the price level will fall until the real value, or purchasing power, of the money supply has returned to its initial level, enabling people to again make their desired purchases. This will occur when the price level has fallen proportionately to the decline in the money supply. At the same time, since nothing has happened to affect the economy’s productive capacity—which is determined by the availability of factors of production and technology—a change in the money supply will have no long-run effect on real GDP.
