Question

Using TE and AD/AS, explain and diagrammatically depict the effect of an increase in the money supply on P and Y in the short-run and the long run. I want the first period's equilibrium, the long-run equilibrium (from self-adjustment) and the story of how the economy adjusts to this monetary shock. Make sure to thoroughly explain what happens to TE as the price level adjusts.

Answer 1

The increase in the money supply reduces the interest rate prevailing in the market. Thus, fall in the interest rate leads to rightward shift in the aggregate demand curve and economy now operates above the full employment level.

Over the long run, the increase in the wage rate owing to rise in inflation would cause the leftward shift in the aggregate supply curve thereby causing fall in the output and rise in the price level.

Following is the diagram:

Short run: in short run demand curve shifts to AD1 and new equilibrium is established at the point B. here output and price both have increased.

Long run: Over the long run, there is rise in the wage rate, and supply curve shift to left AS1, and again output falls to full potential level. and price rises permanently.