Assume that there is equilibrium in both the goods and the money market at all times. Suppose that the president of the United States has decided to start a war. The government will have to increase spending to pay for weapons, equipments, and transportation.

Yes, you are correct. The correct answer is D. The Fed can increase the money supply by the appropriate amount to keep the interest rate at its initial level despite the increase in government expenditure.

To understand why this is the correct answer, let's break it down.

When the government increases its spending, it will put pressure on the demand for goods and services in the economy. This increased demand can lead to an increase in prices, causing inflation. To combat this inflationary pressure, the Fed can use its monetary policy tools to adjust the money supply.

By increasing the money supply, the Fed can lower interest rates. When there is more money available in the economy, banks can lend out more money at lower interest rates, encouraging consumers and businesses to borrow and spend more. This increased spending helps offset the impact of increased government spending, keeping the economy in equilibrium.

So, in summary, if the government increases its spending and the Fed wants to keep the interest rate at its initial level, it can increase the money supply, which lowers interest rates and encourages spending.