Discuss the short- and long-run output responses resulting from an increase in money growth when the economy is producing a current level of output that equals potential output, all other factors constant.
What will be an ideal response?
In the short run, an increase in money growth will shift the dynamic aggregate demand curve to the right. The level of current output will increase. In this case, output takes up the increase in aggregate demand. Over time this will put upward pressure on prices (inflation) and as prices adjust upwards the short-run aggregate supply curve will shift left, and the economy will move up its vertical long-run aggregate supply curve. Once prices (inflation) have fully adjusted the economy will return to its potential level of output, and the increased aggregate demand resulting from increased money growth will result in inflation and not a permanently higher level of potential output.
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