Final answer:
A one-time 4% reduction in the nominal money supply typically leads to a lower price level and a higher real money supply in the medium run. The interest rates may rise and investment could decrease due to the higher cost of borrowing. However, the specific percentage changes are not necessarily directly proportional and will depend on various economic factors.
Step-by-step explanation:
If the economy is originally operating at the natural level of output, and a one-time 4% reduction in the nominal money supply occurs, one would expect the following effects in the medium run:
- A 4% reduction in the price level, as a decrease in the money supply would lead to lower aggregate demand, and with prices adjusting, this would bring the price level down.
- An increase in the real money supply because the reduction in the nominal money supply and the subsequent decrease in the price level make each unit of money worth more in terms of real goods and services.
- Interest rates might initially rise due to a reduced supply of loanable funds, but this is not necessarily a proportional or direct 4% increase. It will depend on the liquidity preference of the public and the reaction of the banking system.
- A reduction in investment could occur because the higher interest rates generally discourage borrowing for investment purposes.
The exact percentages of these changes cannot be predicted with certainty and will depend on a number of factors, including how expectations adjust, the sensitivity of investment to changes in interest rates, and the speed with which prices and wages can adjust in the economy.