Question

Draw the AA/DD model on a graph. Show on the graph the impact of a permanent increase in money supply. What is the impact on the following variables: a. Short-run output b. Long-run output c. Short-run interest rates d. Long-run interest rates e. Short-run exchange rates f. Long-run exchange rates g. Short-run prices h. Long-run prices.

Answer 1

A permanent increase in the money supply of the economy means that the monetary measure taken by the central banks are intended to keep money supply increased in the long term. An increase in the long run money supply means that the money supply curve of the economy will shift to the right. As a result, AA curve of the economy shifts to the right which represents money market equilibrium of the economy. On the other hand, DD curve shows the points where goods market is in equilibrium. A permanent increase in money supply will lead to a rightward shift in the AA curve in the economy. As a result, interest rate will decrease and the quantity of output will increase. It can be shown in the diagram as

Therefore, the short run interest rate will decrease, short run exchange rate will increase, short run output level increases, and price level will also increase due to an increase in the aggregate demand in the economy.

An increase in the permanent money supply will not change the real variables such as real output and nominal interest rates in the long run due to the principle of neutrality of money. On the other hand change in other variable such as long run interest rate and price level can be shown by time path as follows:

As we see, the long run money supply increases as the increase in money supply is permanent. Interest rate will decrease initially but will increase and will get back to initial position in the long run. Price will increase gradually after increase in the money supply and the exchange rate will increase initially but this increase will decrease in its magnitude in the long run.