Final answer:
To stabilize output at potential when the aggregate demand parameter increases, the central bank should buy government bonds as part of an expansionary monetary policy, boosting investment and net exports to shift the aggregate demand curve right.
Step-by-step explanation:
If the aggregate demand parameter increases and the central bank wishes to stabilize output at potential, the central bank should engage in expansionary monetary policy. This policy is characterized by actions such as buying government bonds to increase the money supply. When the central bank buys government bonds, the demand for bonds increases, leading to a rise in bond prices and a decrease in interest rates, which in turn stimulates investment. The reduction in the interest rate also affects the exchange rate, encouraging a boost in net exports. Together, these factors shift the aggregate demand curve to the right, closing any recessionary gap and stabilizing output.
In this scenario, if the aggregate demand parameter increases and the central bank wishes to stabilize output at potential, it should expand the money supply. By expanding the money supply, the central bank increases the availability of funds in the economy, which leads to lower interest rates. Lower interest rates encourage borrowing for investment and consumption, thereby stimulating aggregate demand and increasing output. Buying government bonds is one of the options the central bank can use to expand the money supply.