-Assume that the economy is initially in equilibrium at full employment. Suppose that the Fed decreases money supply by 5 percent.
(a) Using an aggregate demand and supply graph (discussed in Chapter 22), explain exactly what happens and why to aggregate output (real GDP) and the inflation rate in the short run.
(b) Using the same aggregate demand and supply graph, explain exactly what happens and why to aggregate output (real GDP) and the inflation rate in the long run.
Higher money supply will increase aggregate demand, therefore shifting AD curve rightward, increasing both price level and real GDP in short run.
This will create an inflationary gap.
In following graph, AD0, SRAS0 and LRAS0 are initial aggregate demand, short run aggregate supply and long run aggregate supply curves intersecting at point A with price level P0 and real GDP (= potential GDP) Y0. As AD shifts right to AD1, it intersects SRAS0 at point B with higher price level P1 and higher real GDP Y1, creating inflationary gap equal to (Y1 - Y0).
(b) In the long run, higher price level increases cost of inputs and producers reduce output. Aggregate supply falls, and SRAS shifts leftward to SRAS1, intersecting AD1 at further higher price level P1 but at potential and real GDP Y0, eliminating inflationary gap.
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