Let's start with an economy in long run equilibrium, with the price level equal to that anticipated by decision makers. The long run equilibrium is shown by the green dot (1) with the price level at 105.
If starting from this situation, the Fed increases the money supply, banks will increase their lending activity. When the supply of loans goes up, the real interest rate will fall. As the interest rate falls, aggregate demand will increase (move to the right). The following short run equilibrium results.
In this short run equilibrium, which is shown as point (2):
1. the price level is higher than what was expected (it’s 110 instead of 105)
2. the price level is higher than in the (previous) long run equilibrium
3. as a result of the higher price level, producers will produce more output in the short run than in the previous long run equilibrium, since resource costs will not keep up with the higher price level for products (see below)
4. output (real GDP) will be higher than in long run equilibrium (and higher than the potential, sustainable, full employment level).
5. employment is greater than full employment
6. unemployment is lower than the natural rate (this can occur temporarily)
7. cyclical unemployment is negative (which can happen temporarily)
8. the real values of wages and resource prices will be lower than their lower than their long run equilibrium levels (due to the higher than expected price level)
9. real interest rates will be lower than long run equilibrium values (due to Fed action)
Self-Correcting Mechanism
This short run equilibrium will affect the resource market. As the aggregate demand begins to move rightward, producers expand their production in response, and thus increase demand for resources. Real wages and resource prices will be bid up, decreasing short run aggregate supply. As this occurs, the price level will rise, raising the real interest rate back to the long run equilibrium level.
Eventually, a new long run equilibrium will be established, reflecting the restored real wages and resource prices.
At the final long run equilibrium (3),
1. the price level is as expected (it’s 117 now, and that’s consistent with expectations)
2. the price level is higher than in the (previous) long run equilibrium
3. even though the price level is higher than the previous equilibrium, producers do not want to produce more than the long run potential GDP, since resource prices have caught up with product prices.
4. output (real GDP) will be the potential, sustainable, full employment level.
5. employment is equal to full employment
6. unemployment is at the natural rate
7. cyclical unemployment is zero
8. real wages return to their original level, even though nominal wages are higher than before.
9. real interest rates will rise back to their original level, as the economy slides up the aggregate demand curve to the new long run equilibrium.