670 PA R T V I I Monetary Theory reaches AS2, at which time the economy has returned to the natural rate level of output on the long-run aggregate supply curve.1 At the new equilibrium, point 2, the price level has increased from P1 to P2 If the money supply increases the next year, the aggregate demand curve will shift to the right again to AD3, and the short-run aggregate supply curve will shift from AS2 to AS3; the economy will then move to point 2* and then to point 3, where the price level has risen to P3 If the money supply continues to grow in subsequent years, the economy will continue to move to higher and higher price levels As long as the money supply grows, this process will continue, and inflation will occur High money growth produces high inflation Can Other Factors Besides Money Growth Produce a Sustained Inflation? In the aggregate demand and supply analysis of Chapter 24, you learned that other factors besides changes in the money supply (such as fiscal policy and supply shocks) can affect the aggregate demand and supply curves Doesn t this suggest that these other factors can generate persistent high inflation? The answer, surprisingly, is no To see why high inflation is always a monetary phenomenon, let s dig a little deeper into aggregate demand and supply analysis to see whether other factors can generate high inflation in the absence of a high rate of money growth To examine this question, let s look at Figure 26-3, which demonstrates the effect of a one-shot permanent increase in government expenditure (say, from $500 billion to $600 billion) on aggregate output and the price level Initially, we are at point 1, where output is at the natural rate level and the price level is P1 The increase in government expenditure shifts the aggregate demand curve to AD2, and we move to point 1*, where output is above the natural rate level at Y1* The short-run aggregate supply curve will begin to shift leftward, eventually reaching AS2, where it intersects the aggregate demand curve AD2 at point 2, at which output is again at the natural rate level and the price level has risen to P2 The net result of a one-shot permanent increase in government expenditure is a one-shot permanent increase in the price level What happens to the inflation rate? When we move from point to 1* to 2, the price level rises, and we have a positive inflation rate But when we finally get to point 2, the inflation rate returns to zero We see that the one-shot increase in government expenditure leads to only a temporary increase in the inflation rate, not to persistent inflation in which the price level is continually rising If government spending increases continually, however, we could get a continuing rise in the price level It appears, then, that aggregate demand and supply analysis could reject Friedman s proposition that inflation is always the result of money growth The problem with this argument is that a continually increasing level of government expenditure is not a feasible policy There is a limit on the total amount of possible government expenditure; the government cannot spend more than 100% of GDP In fact, well before this limit is reached, the political process would stop the increases in government spending As revealed in the continual debates over balanced budgets and government spending, both the CAN FISCAL POLICY BY ITSELF PRODUCE INFLATION? There is a possibility that the short-run aggregate supply curve may immediately shift in toward AS2 because workers and firms may expect the increase in the money supply, so expected inflation will be higher In this case, the movement to point will be very rapid, and output need not rise above the natural rate level (Some support for this scenario, from the theory of rational expectations, is discussed in Chapter 27.)