1. will shift the LM curve to the right in the long run if there is full employment and flexible exchange rates.
2. will shift the IS curve to the right somewhat if there is less than full employment and fixed exchange rates.
3. will reduce equilibrium money holdings if there is full employment because it represents a tax on holding money.
4. will do all of the above.
Choose the correct option.
The right answer is option 2. The price level will not rise as a result of the increase in the money supply since there is less than full employment. As a result the real money stock, and the level of wealth and permanent income will increase to some degree. This will shift IS to the right as long as the nominal exchange rate does not change. If there is full employment and flexible exchange rates, the LM curve must ultimately remain in its initial position, crossing the ZZ line at the full-employment level of output. By assumption, the tax cut and the increase in the nominal money supply is unanticipated. Hence, the tax on money under flexible prices and full employment is unanticipated and people have no incentive to reduce money holdings to avoid the tax. Equilibrium real money holdings will be unaffected.
The key here is to keep in mind that the real money stock will be unaffected if there is full employment because the price level will rise in proportion to the nominal money stock. The demand for money will not change because the cost of holding money, which equals the real interest rate plus the expected rate of inflation, is unaffected as long as the tax cut and monetary expansion and subsequent price level increase is unanticipated. If there is less than full employment and the price level is fixed the real money stock must increase. In this case the public becomes wealthier and must consume more than previously.