The Council of Elrond has decided to increase taxes, and the central bank of Elrond has decided to conduct open market purchases of financial assets. Assuming that wages are sticky, which of the following best describes the impact of these actions on real output and the price level?

A. Real output will decrease; the price level will decrease.

B. Impact on real output is indeterminate; price level decreases.

C. Real output increases; the price level increases.

D. Impact on real output indeterminate; impact on the price level indeterminate.

D) Impact on real output indeterminate; impact on the price level indeterminate.

Explanation:

An increase in taxes will decrease consumption and aggregate demand, decrease the interest rates, decrease output, decrease price levels and increase investment.

Open market purchase operations (expansionary monetary policy) should increase the money supply, increase aggregate demand, increase output, reduce interest rates and increases price levels.

Increasing taxes should reduce real output and price level, while an expansionary monetary policy does the contrary. It depends on the magnitude of each policy. If the tax increase is high, then total output and price levels will decrease. But if the tax increase was small and the increase in the money supply was very large, then both output and prices will increase.