Final answer:
A favorable supply shock leads to lower price levels and higher real GDP. To counteract this, the central bank would increase the money supply as part of expansionary monetary policy. Therefore, the correct option is C.
Step-by-step explanation:
A favorable (positive) supply shock, such as a decrease in energy prices, causes the Aggregate Supply (AS) curve to shift to the right. This results in more real GDP at a lower price level, leading to a decline in the price level. When a central bank wishes to counteract a positive supply shock to stabilize or increase the economic output ('Y'), it would engage in expansionary monetary policy. This involves increasing the money supply, which lowers the interest rate and encourages borrowing for investment and consumption, thus shifting the Aggregate Demand (AD) curve to the right.
Given the context of the question, the correct answer is c. fall. To counter shock to 'Y' a central bank would increase the money supply. This is because an increase in the money supply will stimulate the economy by encouraging borrowing and investment, counterbalancing the initial increase in supply that led to lower prices.