Question

Explain how the addition of money supply can increase the price in both the short and long term! Explain it with curves!

Answer 1

An increase in money supply shifts money supply curve rightward, which decreases interest rate. Lower interest rate increases investment, which increases aggregate demand, shifting AD curve rightward, increasing both price level and real GDP in short run.

In the long run, higher price level will increase prices of inputs, increasing production costs. Firms will reduce output, decreasing aggregate supply. SRAS shifts leftward, intersecting new AD curve at further higher price level and real GDP being restored to the potential GDP.

In following graph, AD0, LRAS0 and SRAS0 are initial aggregate demand, long-run aggregate supply and short-run aggregate supply curves intersecting at point A with initial price level P0 and real GDP (potential GDP) Y0. When government spending increases, AD0 shifts right to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1.

In long run, 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.