Final answer:
When money demand increases without a corresponding increase in money supply, interest rates increase, leading to a decrease in aggregate demand, real GDP, and the price level. An effective policy response would be for the central bank to increase the money supply to stabilize interest rates and prevent a decrease in aggregate demand.
Step-by-step explanation:
When money demand increases sharply without a corresponding increase in money supply, it leads to an increase in interest rates. This is because as more people want to hold money, they are willing to pay higher interest rates to borrow money. Higher interest rates increase the cost of borrowing and discourage consumption and investment, leading to a decrease in aggregate demand.
In the aggregate supply/demand model, the increase in interest rates will shift the aggregate demand curve to the left, reducing both real GDP and the price level. This is because higher interest rates lead to lower consumption and investment, which are components of aggregate demand. The decrease in real GDP and price level occurs in the short run. An effective policy response to the increase in money demand would be for the central bank to increase the money supply to match the increased demand. By doing so, the central bank can stabilize interest rates, prevent a decrease in aggregate demand, and maintain the level of real GDP and price level in the economy.