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Figure 4. On the left-hand graph, MS represents the supply of money and MD represents the demand for money; on the right-hand

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An increase in price from P1 to P2 causes me net demand curve shift from MD1 to MD2; this shift of MD causes r to increase from R1 to R2 and this increase in R causes Y to decrease from Y1 to Y2.

When there is inflation, the money currently held by people is not enough for smooth consumption. Hence, they demand more money for their transactions. With inflation, the real money supply falls. Thus, with shortage of money supply and more money demand, the interest rate rises. This eventually reduces the investment and further the real GDP.

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