Using the aggregate demand-aggregate supply model, explain and demonstrate graphically the short-run and long-run effects of an increase in the money supply

What will be an ideal response?

See figure below.

An increase in the money supply increases aggregate demand, from AD to AD'. The economy moves from point 1 to point 2. In the short run both inflation rate and real output increase. In the long run, wages adjust, decreasing short-run aggregate supply, to AS', raising prices further and reducing real output until the economy returns to the natural level of output. The long-run result is to only increase inflation. The path is from 1 to 2 to 3.