Final answer:
Increasing the nominal money supply can initially lower interest rates, stimulating GDP and decreasing unemployment. However, as wages and prices adjust, it may lead to inflation without altering real GDP in the long run.
Step-by-step explanation:
When the central bank of Macronesia increases the nominal money supply in the medium run, starting from its natural level of output, several economic effects can unfold. Initially, the increase in money supply would cause interest rates to fall, which in turn would stimulate investment and consumption. This increase in aggregate demand would lead to a rise in gross domestic product (GDP) and a decrease in unemployment due to the higher demand for goods and services.
However, over time, the impact on the real economy tends to diminish and the economy may return to its natural level of output. The increased demand for goods and services, along with the higher costs of production due to increased wages, often leads to higher prices—resulting in inflation.
Moreover, if people anticipate the inflation due to an increase in the money supply, they might adjust their behavior accordingly. Employers, expecting to sell at higher prices, would agree to pay higher wages, and workers, expecting higher living costs, would demand higher wages. This adjustment would shift the short-run aggregate supply curve to reflect the new price level, without changing the real GDP, as per the rational expectations theory. Conversely, a contractionary monetary policy aimed at an economy producing above its potential GDP can help lower inflationary pressures.