Question

25. Draw a graph showing the short- and long-run effects of an increase in the money supply.

Answer 1

Monetary policy is the tool of choice to stabilize the economy. In the long-run, changes in the quantity of money affect the aggregate price level, but they do not change real aggregate output. To assess the effects of changes in the money supply, we can analyze the long-run effects of changes in AD. An increase in the money supply reduces the interest rate, which leads to an increase in investment spending, and a further rise in consumer spending, and so on. An increase in the money supply increases the quantity demanded of goods and services, shifting AD to the right. In the short run, the economy moves to a new short-run equilibrium, where both aggregate price and aggregate output increasing. However, the aggregate output level is above the potential output level which results in an increase in nominal wages over time, causing the SRAS curve to shift leftward. And this process stops when the economy ends up at a point of both short-run and long-run equilibrium. The aggregate price level increases, but the aggregate output is back at potential output. Therefore, in the long run, an increase in the money supply raises the aggregate price level but has no effect on real GDP.