Question

Using an aggregate demand and supply graph, illustrate and describe the following:

a. The short-run effects of an increase in the money supply.

b. The long-run effects of an increase in the money supply.

Short answer

The short-term and long-term effects of a brief negative supply shock.

The short-term and long-term effects of a permanent negative supply shock.

Step-by-step solution

(a) Step 1. Concept of temporary negative supply shock

A transient negative supply shock occurs when the supply of products and services is reduced for a short period of time.

(b) Step 2. Explanation

The following is a diagram depicting the effect of a transient negative supply shock in the short and long run:

Figure out (1)

Where,

- The long run aggregate supply curve is abbreviated as LRAS.

- AS is the aggregate supply curve in the near run.

- The aggregate demand curve is abbreviated as AD. In Figure $1$, the economy moves from point $1$to point $2$. When there is a transitory negative supply shock, inflation rises and output falls below its potential. The inflation expectations are lowered as a result of the negative output gap. Expected inflation declines, bringing the aggregate supply curve back to AS. At this moment, the economy has returned to point $1\text{'}$s initial long-run equilibrium.

(b) Step 1. Concept of permanent negative supply shock 

The term "permanent negative supply shock" refers to a situation in which the supply of products and services is reduced for an extended length of time.

(b) Step 2. Explanation

The following diagram depicts the long-term and short-term effects of a permanent negative supply shock:

Figure out ($2$)

Where,

- The long run aggregate supply curve is abbreviated as LRAS.

- AS is the aggregate supply curve in the near run.

- The aggregate demand curve is A D.

In the case of a permanent negative supply shock, output falls at first and inflation rises. In the case of a permanent negative supply shock, potential production diminishes over time. Point $3$shows how a loss in potential output leads to a permanent drop in output and an increase in inflation (figure $2$ ).