Question

When the Fed decreases the money supply, the equilibrium level of income changes. Why do you think this is? In addition what do you think would happen if the Fed further reduces the money supply? Should there be a legal limit stating how much money the Fed can reduce the money supply.

Answer 1

Fed's act of reducing money supply is to combat inflation in the economy.Reduction in money supply will be encountered only if there is excess of money in circulation,which ultimately leads to higher prices.

But any further reduction in money supply will cause a setback totthe growth of bany economy because this will cause a decline in aggregate demand.

Hence,this reduction process must have a constant legal check over the amount or the quantity to be reduced.