1. Using AD/AS, describe the short-run and long-run effects of an increase in the money supply on the equilibrium level of production and the price level. Be sure to explain what happens to Total Expenditures (using the 3 effects of spending changes as a result of changes in the price level).



2. Using AD/AS, describe the short-run and long-run effects of an increase in the price of oil.

1. Short-run effects of an increase in the money supply:

In the short run, an increase in the money supply will lead to a rightward shift in the aggregate demand (AD) curve. This is because individuals and businesses will have more money to spend, leading to increased consumption and investment. As a result, the equilibrium level of production (output) will increase, leading to higher employment and economic growth.

The increase in money supply will also have an immediate effect on the price level. As people have more money to spend, the demand for goods and services increases, which can lead to upward pressure on prices. In the short run, this will cause the price level to rise.

Total Expenditures (TE) is the product of price level (P) and real GDP (Y). When the price level increases, TE can change through three effects:

a) Real balance effect: As the price level increases, the value of money decreases, reducing consumers' real purchasing power. This leads to a decrease in consumption spending, causing TE to decrease.

b) Interest rate effect: An increase in the price level leads to an increase in the demand for money, causing interest rates to rise. Higher interest rates can discourage investment and borrowing, resulting in a decrease in consumption and investment spending, leading to a decrease in TE.

c) Foreign trade effect: A rise in the price level can make domestic goods relatively more expensive compared to foreign goods. This can lead to a decrease in exports and an increase in imports, reducing net exports and total expenditures.

Long-run effects of an increase in the money supply:

In the long run, the effects of an increase in the money supply differ from the short run. In the long run, the aggregate supply (AS) curve is vertical, indicating that changes in the money supply do not impact the equilibrium level of production. Instead, the increase in the money supply only leads to an increase in the price level.

In the long run, wages and prices adjust to changes in the money supply. As prices rise, workers and firms expect higher prices, resulting in higher wages and production costs. This adjustment process eventually restores the economy to its original equilibrium level of output. Therefore, the long-run effects of an increase in the money supply result in an increase in the price level, but no sustained changes in output or employment.

2. Short-run effects of an increase in the price of oil:

In the short run, an increase in the price of oil will lead to a leftward shift in the aggregate supply (AS) curve. This is because higher oil prices increase production costs for businesses, which leads to a decrease in aggregate supply. As a result, the equilibrium level of production (output) will decrease, leading to lower employment and economic growth.

The increase in the price of oil will also have an immediate effect on the price level. Higher oil prices increase production costs for firms, which can cause firms to pass on these higher costs to consumers in the form of higher prices. In the short run, this will cause the price level to rise.

Long-run effects of an increase in the price of oil:

In the long run, the effects of an increase in the price of oil are different. While the short-run impact is a decrease in output and an increase in the price level, in the long run, the economy adjusts.

As oil prices increase, firms will seek to reduce their dependence on oil, adopt more energy-efficient technologies, and find alternative energy sources. These adjustments will gradually reduce production costs and allow the economy to return to its original level of output. Therefore, in the long run, the increase in the price of oil has no sustained impact on output or employment, but it may lead to higher prices depending on other factors affecting the economy.

To answer these questions using the AD/AS framework, we need to understand the basics of Aggregate Demand (AD) and Aggregate Supply (AS).

1. Short-run effects of an increase in the money supply:
In the short run, an increase in the money supply will affect the economy as follows:
- Aggregate demand (AD) shifts to the right, indicating an increase in the overall level of spending in the economy.
- As a result, the equilibrium level of production will increase, leading to higher levels of output and employment.
- The price level, on the other hand, will also increase due to the increase in spending.

Total Expenditures:
When the price level rises due to the increase in spending, total expenditures can be analyzed using the three effects of spending changes:
a) Wealth effect: As the price level increases, the purchasing power of consumers decreases, leading to lower real wealth. This decrease in wealth generally leads to a decrease in consumption spending and thus reduces total expenditures.
b) Interest rate effect: When the price level increases, people demand higher money balances to maintain their purchasing power. This increased demand for money increases interest rates, which can lead to a decrease in investment spending, further reducing total expenditures.
c) Net exports effect: An increase in the price level may lead to an increase in the domestic price level relative to foreign prices, which reduces net exports. This reduction in net exports decreases total expenditures.

Long-run effects of an increase in the money supply:
In the long run, changes in the money supply primarily affect the price level, but not the level of production. Here's what happens:
- Aggregate supply (AS) is assumed to be vertical in the long run, meaning that changes in the money supply do not impact the production capacity of the economy.
- As the money supply increases, the increase in aggregate demand will eventually lead to an increase in the price level, but it will not affect the equilibrium level of production.
- Therefore, in the long run, the price level increases proportionally to the increase in the money supply, while the level of production remains unchanged.

2. Short-run effects of an increase in the price of oil:
When the price of oil increases, it affects the economy in the following manner:
- Aggregate supply (AS) shifts to the left, indicating a reduction in the overall level of production and output in the economy.
- This reduction in production leads to a higher price level due to the decrease in supply.

Long-run effects of an increase in the price of oil:
In the long run, changes in the price of oil primarily affect the price level, but not the level of production. Here's what happens:
- Similar to the money supply example, the long-run aggregate supply curve is vertical, indicating that changes in the price of oil do not impact the production capacity of the economy.
- As the price of oil increases, the increase in aggregate supply will eventually lead to an increase in the price level, while the level of production remains unchanged.

Overall, changes in the money supply impact both the level of production and the price level, whereas changes in the price of oil primarily impact the price level. It's important to note that these are simplified explanations using the AD/AS framework, and real-world economic factors can be more complex.