1. Suppose the Federal Reserve increases the money supply by 5 percent. Assume the velocity of money is constant. a. What happens to the aggregate demand curve? An increase in money supply would shift the aggregate demand curve out (increase). b. What happens to the level of output and the price level in the short run and in the long run. Be sure to tell the story of why the economy adjusts. In other words, how do people change their behavior in response to the change in the money supply?

a. When the Federal Reserve increases money supply, the cost of money becomes cheaper i. e. interest rates fall.

This means more money is available to spend for consumers and businesses.

This also leads to a depreciation in the value of a nation's currency which in turn increases the demand for the goods and services of the country in the international market.

Hence the Aggregate Demand Curve shifts to the right from its original position.

b. In the short run, as the money supply increases, the demand for money remains the constant. This results in a fall in interest rates. A fall in interest rates puts more money in the hands of consumers who demand more products and services. In the short run, however, the supply of goods and services are fixed and hence an increase in demand leads to inflation and higher price levels.

The higher price levels induce business to borrow at low interest in order to increase the production of goods and services. This leads to an increase in real output over the long run and the economy reaches a new equilibrium.

However, as businesses expand, the demand for labor in the labor market also goes up and so does the cost of labor. This leads to a rise in the cost of production. Hence in the long run, the increase in the supply of goods and services only satisfies a part of the increase in demand represented by the shift in the Aggregate Demand Curve.

Hence over the long run the general level of prices will also rise.