Question

Using AD/AS model and diagrams, discuss the short-run and long-run impacts of the following events
on the price level and output of the domestic economy (starting from the full-employment level):
a. An increase in money supply
b. An increase in the demand for housing by foreigners

Answer 1

In each graph, AD0, LRAS0 and SRAS0 are initial AD, long run Aggregate Supply curve and short run Aggregate Supply curves intersecting at point A with initial long run equilibrium price level P0 and real GDP (= Potential GDP) Y0.

(b) Increase in money supply will increase aggregate demand, shifting AD curve toward right, increasing both price level and real GDP which gives rise to an inflationary gap in short run. In the long run, higher price level will increase cost of input, so firms will decrease output and aggregate supply will reduce, shifting SRAS to left, and new long run equilibrium is at a further higher price but real GDP will be equal to potential GDP, eliminating short run inflationary gap. In following graph, as AD0 shifts right to AD1, it intersects SRAS0 at point B with higher price level P1 and higher real GDP Y1, causing inflationary gap equal to (Y1 - Y0) in short run. In long run, as SRAS0 shifts left to SRAS1, it intersects AD1 & LRAS0 at point C with still higher price P2 and real GDP is restored to potential GDP of Y0, eliminating the short run inflationary gap.

(b) Higher demand for housing by foreigners is equivalent to an increase in exports which increases net exports, which will increase aggregate demand, shifting AD curve toward right, increasing both price level and real GDP which gives rise to an inflationary gap in short run. In the long run, higher price level will increase cost of input, so firms will decrease output and aggregate supply will reduce, shifting SRAS to left, and new long run equilibrium is at a further higher price but real GDP will be equal to potential GDP, eliminating short run inflationary gap. In following graph, as AD0 shifts right to AD1, it intersects SRAS0 at point B with higher price level P1 and higher real GDP Y1, causing inflationary gap equal to (Y1 - Y0) in short run. In long run, as SRAS0 shifts left to SRAS1, it intersects AD1 & LRAS0 at point C with still higher price P2 and real GDP is restored to potential GDP of Y0, eliminating the short run inflationary gap.