Question

Describe how a decrease in the money supply on the economy causes the AD curve to shift. What is the effect on the price level and output in the short run? In the long run?

Answer 1

A decrease in money supply leads to increase in interest rate.

An increase in interest rate increases the cost of borrowing for the households and businesses.

This compels the households and businesses to decrease their consumption spending and investment spending backed by credit.

Consumption and investment are components of aggregate demand.

So, this decrease in consumption spending and investment spending leads to decrease in aggregate demand.

This decrease in aggregate demand will shift the aggregate demand curve to the left.

Given the short-run aggregate supply curve, this leftward shift of the aggregate demand curve will lead to fall in price level and output.

So, in short-run, price level and output will decrease.

Fall in output will result in an increase in unemployment. This will lead to fall in wage rate. As wage rate will fall, production costs of firms will decrease and their profit margin will improve.

So, over time, they will increase their production and this would shift the short-run aggregate supply curve to the right.

Thus, in long-run, price level will decrease further and economy will return to its potential output level.