Final answer:
If there's a reduction in government purchases, the Federal Reserve might increase the money supply to maintain real interest rates. This could lead to a short-term boost in GDP and a reduction in unemployment, but risk longer-term inflation if not matched with economic growth.
Step-by-step explanation:
If there were a reduction in government purchases, and the Federal Reserve's short-run response is to maintain the existing real interest rates, then the Fed would likely increase the money supply. This action would counteract the contractionary effect of reduced government spending.
A decrease in government purchases would potentially lower aggregate demand, leading to a potential decrease in the GDP and a possible increase in unemployment. To moderate these effects, an increased money supply would aim to encourage borrowing and spending, thus stimulating the economy. This can, however, lead to higher inflation if not carefully managed.
When the Federal Reserve increases the supply of money at an increasing rate, it would typically result to a short-term increase in GDP as businesses and consumers are encouraged to spend and invest due to the lower interest rates. Unemployment might also decrease because increased spending can lead to higher demand for goods and services, and consequently, for labor. However, over the long term, if the increase in the money supply is not in line with economic growth, this could lead to higher inflation rates.