Final answer:
The effect of an increase in the money supply on aggregate demand will be larger if the SRAS is relatively flat and the interest rate decreases. This scenario would lead to a significant increase in real GDP without substantially increasing price levels.
Step-by-step explanation:
If the Federal Reserve (the Fed) increases the money supply, the effect on aggregate demand in the short-run depends on how the interest rates change and the slope of the short-run aggregate supply curve (SRAS). When the Fed increases the money supply, interest rates generally fall. This lower interest rate stimulates investment and can lead to an increase in net exports, both of which will shift the aggregate demand curve to the right.
If the SRAS is relatively steep, changes in aggregate demand have a larger impact on the price level and a smaller impact on real GDP. However, the greatest impact of an increased money supply on aggregate demand would be seen if the SRAS is relatively flat. In this case, a decrease in interest rates (scenario C - the interest rate falls and SRAS is relatively flat) would lead to a larger increase in real GDP without putting significant upward pressure on the price level, thus making the effect on aggregate demand larger.