Q. Explain the following figure:

Answer: The figure depict the effect of a permanent increase in the money supply starting from full employment equilibrium. Subsequent to the initial increase in the money supply and the move of the AA curve to the right from AA¹ to AA² a steadily increasing price level shifts the AA and the DD schedules to the left until a new long-run equilibrium is reached.   Note that point 3 is above point 1 for the reason that Ee is permanently higher after a permanent raise in the money supply.  The expected exchange rate, Ee has increase by the same percentage as Ms. Notice that beside the adjustment path among the initial short-run equilibrium (point 2) and the long-run equilibrium (point 3) the domestic currency actually appreciates (from E² to E³) following its initial sharp depreciation (from E¹ to E²).