(Monetary Policy and Aggregate Supply) Assume that the economy is initially in long-run equilibrium. Using an AD–AS diagram, illustrate and explain the short-run and long-run impacts of an increase in the money supply.

To understand the short-run and long-run impacts of an increase in the money supply on the economy, we can use an AD–AS diagram.

1. Start with the long-run equilibrium:
- Draw an upward-sloping aggregate supply (AS) curve representing potential output at full employment.
- Draw a downward-sloping aggregate demand (AD) curve representing the total spending in the economy.

2. In the long run, the AD and AS curves intersect at the natural level of output, where there is no inflationary or deflationary pressure. This represents the long-run equilibrium.

3. Now, let's consider the short-run impact of an increase in the money supply:
- When the money supply increases, it leads to an increase in spending by individuals and firms.
- As a result, the AD curve shifts to the right (AD1), indicating higher total spending in the economy.
- In the short run, the increase in aggregate demand stimulates production and employment.

4. In the short run, we observe:
- Output increases, leading to higher employment and potentially lower unemployment rates.
- Firms might raise prices due to higher demand, resulting in a temporary increase in inflation or inflationary pressure.

5. However, in the long run, wages and prices are flexible and adjust to changes in demand:
- As firms respond to increased demand, they hire more workers and increase wages, pushing up production costs.
- Higher wages and production costs shift the AS curve leftward (AS1).
- Eventually, the economy moves from the short-run equilibrium back to the long-run equilibrium.

6. In the long run, we observe:
- The increase in the money supply leads to higher prices (inflation) and not a sustained increase in output or employment.
- The AS curve settles back to its original position, intersecting with the AD curve at the potential level of output or full employment.

In summary, an increase in the money supply has short-run effects of stimulating output and employment, potentially causing inflation. However, in the long run, wages and prices adjust, returning the economy to the initial long-run equilibrium.