Explain the following figure:

Answer: The figure depicts the effect of a permanent increase in the money supply starting from full employment equilibrium. After 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, because E^e is permanently higher after a permanent increase in the money supply. The expected exchange rate, E^e , has risen by the same percentage as M^s. Notice that along the adjustment path between 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).