Final answer:
To bring the economy back to the initial long-run equilibrium (P*, PGDP), the Fed needs to increase interest rates, shifting the aggregate demand curve to the right. Therefore, the correct option is D.
Step-by-step explanation:
The correct statement is Option D: increase interest rates, AD shifts right. When the Federal Reserve (the Fed) increases interest rates, it makes borrowing more expensive for businesses and consumers. This decrease in borrowing reduces investment and spending, shifting the aggregate demand (AD) curve to the left. As a result, the economy moves away from the initial long-run equilibrium.
To bring the economy back to the initial equilibrium, the Fed needs to increase interest rates, which in turn reduces borrowing costs and encourages more investment and spending. This increases the aggregate demand and shifts it to the right, bringing the economy back to the initial long-run equilibrium (P*, PGDP).