Final answer:
An increase in the money supply, with all else being equal, will lead to an increase in the price level. This corresponds to the basic quantity equation of money, where if velocity and real GDP are constant, changes in money supply directly affect the price level.
Step-by-step explanation:
The equation of exchange, represented as Money Supply (M) x Velocity of Money (V) = Nominal GDP, which further breaks down into Price Level (P) x Real GDP (Y), illustrates a relationship where, if the velocity of money (V) and the quantity of goods and services (Real GDP, Y) are held constant, an increase in the money supply (M) would lead to an increase in the price level (P). This is because, with V and Y being constant, any change in M must accordingly manifest as a change in P.
Subsequently, if the money supply decreases and the other variables remain constant, the equation suggests that the price level would decrease, not increase. Therefore, the correct final answer to the student's question is (C) an increase in the money supply will increase the price level. This phenomenon is also theoretically consistent with inflation, where more money chases the same number of goods, leading to higher prices.