The increase in the MS increases AD from AD 0 to AD 1 . The change in price expectations shifts AS 0 to AS 1 simultaneously. Output is unchanged at Q p . Same thing happens in the next period. The Fed once again announces that it will increase the MS .
Agents anticipate the change in the price level.
The resulting simulataneous shifts in AD and AS offset one another, leaving output at Q p and yielding a higher price level at p 2. If the Fed decreases the money supply agents will overestimate and real output will fall below the potential level to Q 1 . This is really an argument against permanently lowering output below the potential level of output and, equivalently, permanently lowering the rate of unemployment below the natural rate of unemployment. But, note that the force of the argument does not address the issue of reducing unemployment and raising output when the economy is performing below the natural rate of unemployment and below potential output. If you believe that expectations take time to adjust, then when there are slack resources the Fed can use expansionary monetary policy to try to increase AD and move the economy back towards Q P and L N .