Question

Explain and demonstrate graphically, the short-run and long-run effects of an increase in the money supply using the AD-AS model.

Answer 1

An increase in money supply lowers interest rate, which increases investment demand and the component of consumption demand that is funded by borrowing. This increases aggregate demand. AD curve will shift to right, increasing both price level and real GDP, resulting in a short-run inflationary gap.

In the long run, higher price level increases input costs, raising production costs. Hence firms decrease production, lowering aggregate supply. SRAS curve shifts leftward, intersecting new AD curve at further higher price level but restoring real GDP to potential GDP level, and eliminating expansionary gap.

In following graph, initial 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 higher consumption and investment increases aggregate demand, AD curve will shift rightward from AD0 to AD1, intersecting SRAS0 at point B with higher price level P1 and higher real GDP Y1, with inflationary gap being equal to (Y1 - Y0) in short run. 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, eliminating short-run inflationary gap.