Question

1. Assume that the economy is initially in equilibrium at full employment.  Suppose that the Fed increasesmoney supply by 5 percent.

1. (8 POINTS)Using an aggregate demand and supply graph(discussed in Chapter 22), explainexactly what happens and why to aggregate output (real GDP) and the inflation rate in the short run.
2. Using the same aggregate demand and supply graph, explainexactly what happens and why to aggregate output (real GDP) and the inflation rate in the long run

Answer 1

(a)

Increase in money supply decreases interest rate, raising investment demand, thereby increasing aggregate demand. AD curve will shift to right, increasing price level (inflation) and increasing real GDP, giving rise to an expansionary gap in short run.

In following graph, long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with initial long-run equilibrium price level P0 and initial equilibrium real GDP (= Potential GDP) Y0. When money supply rises, AD curve shifts rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, with inflationary gap of (Y1 - Y0).

(b)

In the long run, higher price level raises input costs, so firms lower production, decreasing aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level but restoring original real GDP and removing the inflationary gap. In above graph, SRAS0 shifts left to SRAS1, intersecting AD1 at point C with further higher price level P2 and restoring real GDP to potential GDP level Y0.