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    Rational Expectations

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    18. (Rational Expectations) Using an AD-AS diagram, illustrate the short-run effects on prices, output, and unemployment of an increase in the money supply that is correctly anticipated by the public. Assume that the economy is initially at potential output.

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    Aggregate demand is influenced almost entirely by the amount of money in the economy, namely the money supply. Inflation is caused by the amount of money in the economy and hence the spending power of the population exceeding the capacity of the country to produce goods and services.
    Policies that result in increases in the money supply such as attempts to stimulate the national income of a country will only have short-term effect on real output but generate inflation. Increased money supply will lead to increases in spending through transmission mechanisms and this will invariably create a situation where aggregate demand for goods and services exceeds the aggregate supply resulting in ...

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    Illustration of the short-run effects on prices, output, and unemployment of an increase in the money supply that is correctly anticipated by the public.

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