Final answer:
Increasing the money supply initially boosts GDP and lowers unemployment due to increased aggregate demand, but leads to inflation. Eventually, the economy returns to potential GDP, with inflation being a more persistent outcome, especially if the money supply continues to grow at an increasing rate.
Step-by-step explanation:
If the Federal Reserve begins to increase the supply of money at an increasing rate, there would be several effects on the economy, including impacts on Gross Domestic Product (GDP), unemployment, and inflation. Initially, an increased money supply may lead to lower interest rates, which stimulates investment and consumer spending, shifting the aggregate demand (AD) curve to the right. This can lead to higher GDP and lower unemployment as businesses increase production to meet higher demand and hire more workers. However, this greater demand can also put upward pressure on prices, leading to inflation.
In the short run, increasing the money supply can boost economic output and reduce unemployment, but this comes at the cost of higher inflation. Over time, if the money supply continues to grow, the economy can overheat, leading to high inflation rates. When the AD curve shifts in the Aggregate Supply (AS) curve's relatively flat portion, the changes in output and price level can be substantial. However, in the long run, neoclassical economics suggests that the economy tends to return to its potential GDP, with any gains in employment or GDP being temporary and inflation being the more persistent outcome.
The speed of macroeconomic adjustment depends on how quickly wages and prices can adjust. Keynesian economists argue that this adjustment can take a very long time, meaning that the economy may stay at an elevated level of inflation and reduced unemployment for a while before returning to potential GDP.