Question :

The long-run position of an economy is described by the quantity theory of money:

M/P = L (Y, r)

Where M: nominal money stock; P: price level; Y: real income and r: interest rate

This economy does not immediately adjust to equilibrium, so we can distinguish both short run and long run effects. The economy is in equilibrium.

Suppose there is a demand shock - namely a 10% increase in nominal money supply used to finance an increase in government expenditure.

(i) By what percentage will nominal income change?
(ii) Describe the effects upon real income and the price level in the short run.
(iii) Describe the effects upon real income and the price level in the long run.

Suppose now that the economy, again from equilibrium, experiences a supply shock, say, an increase in the cost of a vital raw material

(iv) Describe the short run effect of the supply shock.