Adjustment to a Permanent Increase in the Money Supply
The central bank does not reverse the increase in the money supply shown in
Figure
1714,
so it is natural to ask how the economy is affected
over time
. At the short-run equilib
rium, shown as point 2 in Figure
1714, output is above its full-employment level and
labor and machines are working overtime. Upward pressure on the price level
develops
as workers demand higher wages and producers raise prices to cover their
increasing
production costs.
Chapter 15 showed that while
an increase in the money supply must
eventually cause all money prices to rise in proportion, it has no lasting effect on
out
put, relative prices, or interest rates. Over time, the inflationary pressure that
follows
a permanent money supply expansion pushes the price level to its new long-run
value
and returns the economy to full employment.
Figure
1715 will help you visualize the adjustment back to full employment.
Whenever output is greater than its full-employment level,
Y
f
,
and productive factors
are working overtime, the price level
P
is rising to keep up with rising production costs.
Although the
DD
and
AA
schedules are drawn for a constant price level
P
, we have seen
how increases in
P
cause the schedules to shift. A rise in
P
makes domestic goods more
expensive relative to foreign goods, discouraging exports and encouraging
imports.
FIGURE
1714
Short-Run Effects
of a Permanent Increase
in the Money Supply
A permanent increase in
the money supply, which
shifts
A
A
1
to
A
A
2
and moves
the economy from point
1 to point 2, has stronger
effects on the exchange rate
and output than an equal
temporary increase, which
moves the economy only to
point 3.
Exchange
rate,
E
Y
f
Output,
Y
2
E
2
1
E
1
Y
2
3
D
D
1
AA
2
AA
1
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