The Central Bank increases the money supply by 5%. This was not anticipated by economic participants. The economy is operating below potential. In the long- run, this will cause the aggregate supply curve to _______, the aggregate demand curve to ________, and the price level to ________.
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A. B. C. D. E. F.A
In order to determine how each curve changes, think of the effects independently. First the demand curve. The new money supply is effectively new income for consumers, it is irrelevant for this exercise whether this is real or nominal income. An increase in income shifts the demand curve to the right.
Next the supply curve. If producers anticipate inflation, this is effectively an increase in their costs. Again, whether this is a nominal or real cost increase is irrelevant. Higher costs cause the supply curve to shift to the left.
The directional shift in both curves indicates a higher price level. Note that the quantity demanded/produced is the same. This is because while the increase in income shifts the demand curve, the increase in prices offsets the effect. Similarly, the increase in revenues (due to higher prices) offsets the higher costs for suppliers.