Final answer:
The correct answer is option c. Monetary policy affects the economy by influencing interest rates, which impacts borrowing for investment. Expansionary policy lowers rates and stimulates borrowing, increasing GDP and the price level. Contractionary policy does the opposite, raising rates, reducing borrowing, and thus decreasing GDP and the price level.
Step-by-step explanation:
Monetary policy primarily affects the economy by influencing the level of interest rates, which in turn affects the willingness of individuals and businesses to engage in borrowing for various purposes. When the central bank implements an expansionary monetary policy, it increases the supply of money and loanable funds, leading to lower interest rates. This encourages more borrowing for investment and consumption, which shifts aggregate demand right, increasing real GDP and the price level in the short run.
Conversely, a contractionary monetary policy involves decreasing the supply of money and credit, which raises interest rates and discourages borrowing. This leads to a leftward shift in aggregate demand, resulting in lower real GDP and price level in the short run. Additionally, higher domestic interest rates can lead to an appreciation of the currency, which can reduce exports and increase imports, further affecting aggregate demand negatively.