Suppose an economy is in long-run equilibrium. The central bank raises the money supply by 5 percent.

Use your diagram to show what happens to output and the price level as the economy moves from the initial to the new short-run equilibrium.

Short-run ags, long-run vertical ags, vs aggregate demand (type of graph) –> short-run aggregate supply curve shifts to the right

Now adjust the graph to show the new long-run equilibrium.

What causes the economy to move from its short-run equilibrium to its long-run equilibrium?

The government must increase spending to increase aggregate demand.

Nominal wages, prices, and perceptions will adjust upward to this new price level.

The government must increase taxes to curb aggregate demand.

Nominal wages, prices, and perceptions will adjust downward to this new price level.

According to the sticky-wage theory of aggregate supply, nominal wages at the initial equilibrium are greater than nominal wages at the short-run equilibrium and greater than nominal wages at the long-run equilibrium. real wages at the initial equilibrium are greater than nominal wages at the short-run equilibrium and greater than nominal wages at the long-run equilibrium. judging by the impact of the money supply on nominal and real wages, this analysis is not consistent with the proposition that money has real effects in the short run but is neutral in the long run.

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