Another Teachable Moment

Economists from KNZN, to Byran Kaplan to apparently Greg Mankiw have stopped by Modeled in the past. I am hoping to catch one of them or anyone else in the blogosphere who can explain the following quandary to me.

How can we feel comfortable assuming that increases in the money supply feed directly into increases in nominal demand?

Here is the quandary as it occurs to me. Increases in nominal demand lead to increases in prices. But don't we need increases in prices to see increases nominal demand?

Suppose that we live in an economy with no technological growth and no population change so that every period is the same as the one before. There is a constant money supply until time some time t0.

At t0 the money supply doubles. At this particular moment nothing has happened to prices. So everyone has just received a real increase in their transitory income. They should then attempt to smooth it out by saving it.

This drives down the interest rate. This should encourage accumulation of more capital and an increase in consumption and as such an increase in aggregate demand. Yet, I see no reason to suppose that the increase in demand would be proportionate.

Capital and consumer durables should be favored. Furthermore, there are those who posses scare inputs in the production of these goods. They should see real increases in relative demand. This should lead to an increase in their demand for labor.

It seems that price increases for the rest of the economy should come primarily from labor moving into the durables market away from non-durables. This run up in price would decrease the value of the extra money leading to a slow unraveling of this process.


However, I cannot see how it is in any one's interest to raise prices before they face a decrease in labor supply, nor how it is in the interest of the consumer to spend more on non-durables before the price goes up. It would seem that the whole thing has to work its way through the durables market.

Furthermore, as long as there is some time cost associated with changing jobs this process will take time.

As far as I can tell this seems largely consistent with what happens in the world. What is wrong with my story?

Update: Just to be clear. This is a geniune question not a see who can get the answer question.