In the following questions, we will understand what happens to the money market when the fed

increases of decreases the supply of the money and what factors get influenced by this decision
in the short run.

Answer to the question 2 (a)

From The question, we can state that the change in money supply will decrease the interest rate
or the equilibrium interest rate. Which means that the spending of the household will be
increased and the investment of the firms will also be increased. And for this cumulative effect,
the demand curve of money will shift to the right which will increase the interest rate and the
quantity of money.
 Answer to the question 2 (b)

Model of aggregate demand and supply use to simplify the effect of any increase or decrease of
demand for money on output level and given price level.

As per the discussion of previous answer A, it can be said that lower interest which is caused by
increment of money supply leads to the higher aggregate demand for money as well as an
increment in output level. Pricing level will not be changed as we know that the price level is
assumed to be fixed in the short-run effect of aggregate supply. So, the ultimate change is made
on aggregate demand which will be clarified through the given curve.

Price level :

SRAS

AD2
Ad1

Output Y
 Answer to the question 2 (c)

By the data given in the question, the central bank expands money supply by 5 percent. This
results in an increased aggregate demand and increased output in the short run to maintain the
equilibrium.

When the economy makes the transition from its short-run equilibrium to its long-run
equilibrium, the price level increases and the output returns to the natural-rate level again.

This increase in the price level is explained in the given illustration. In the short-run, the price
level is sticky and do not change. As the aggregate demand rises from AD1 to AD2, the output
level rises from Y1 to Y2 and the equilibrium moves from point A to point B. Due to high
demand, eventually in the long run the prices rise from P1 to P2. This increase in price level
moves the economy or the equilibrium along the new aggregate demand curve AD2 to point C to
maintain equilibrium. This is the new long-run equilibrium point.

So, as the economy makes transition from its short-run equilibrium to its long run equilibrium,
the output adjusts itself to its natural level and the prices rise.
Conclusion

Concluding the above answers in a summary, when the central bank increases the money supply
the interest rate declines and the aggregate demand increases. In the short run, this increased
aggregate demand results in higher level of output but an unchanged price level because the price
level is sticky in the short run. When the economy makes transition from its short-run
equilibrium to its long run equilibrium, the price level eventually increases and the output adjusts
itself to its natural-rate level again.