Question

Suppose that inflation expectations increase. Assuming that the Fed wants to keep the price level constant, what must it do to achieve a long-run equilibrium in the real money market?

Answer 1

If there is expectation of rise in inflation, consumers will consume more goods now to avoid higher price in the future. It will raise aggregate now and shift demand curve to its right from AD to AD1 which raise price from P to P1 and output from Q to Q1 in short run. If Fed to maintain constant price level in long run, they must adopt expansionary monetary policy which will reduce rate of interest and induce investors to spend more money because there is fall in cost of borrowing money and shift supply curve to its right from S to S1. It lower price level agsin to its initial level and raise output level further to Q2. Thus, money supply should be increased in real money market in long run.