Monetary Policy & Aggregate Demand Chapter 14-3.  Expansionary monetary policy is monetary policy that increases aggregate demand.  Contractionary monetary.

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Presentation transcript:

Monetary Policy & Aggregate Demand Chapter 14-3

 Expansionary monetary policy is monetary policy that increases aggregate demand.  Contractionary monetary policy is monetary policy that reduces aggregate demand.

Expansionary Monetary Policy to Fight a Recessionary Gap

Contractionary Monetary Policy to Fight an Inflationary Gap

Monetary Policy in the AS/AD Model**  In AS/AD model, monetary policy is seen working primarily through its effect on interest rates.

Contractionary Monetary Policy  The Fed decreases the money supply.  The interest rates go up.  As interest rates go up, the quantity of investment goes down.

Contractionary Monetary Policy  As investment goes down, aggregate demand goes down. Aggregate equilibrium demand and income go down by a multiple of decrease in investment.

Contractionary Monetary Policy in the AS/AD Model* Short-run aggregate supply Y Real output Price level Y1Y1 P1P1 P0P0 Y0Y0 AD 0 AD 1 MiI

Expansionary Monetary Policy* Real output Price level Y0Y0 P0P0 P1P1 Y1Y1 AD 1 AD 0 MiIY

Monetary Policy in the Circular Flow*  Expansionary monetary policy tries to expand the economy by channeling more saving into investment.  Contractionary monetary policy tries to reduce inflationary pressures by restricting demand for consumer loans and investment

Monetary Policy in the Circular Flow

Interest Rates and Spending  Changes in interest rates affect consumer, investor, government, and net export spending.

Monetary Stimulus  The goal of monetary stimulus is to increase aggregate demand.  Aggregate Demand – The total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

Monetary Stimulus  The way to increase aggregate demand is to lower interest rates.

Investment  Lowering interest rates encourages investment due to the lower cost of borrowing.

Aggregate Demand  The increased investment caused by lower interest rates represents an injection of new spending into the circular flow.

Aggregate Demand  The increase in investment will kick off multiplier effects and result in an even larger increase in aggregate demand.

Multiplier Effects Real GDP ($ trillions per year) Price Level (average price) P1P1 5.6 QEQE AD 2 AD 3 Current price level Direct impact of increase Investment spending + $200 billion AD 1 a b Indirect impact via increased consumption + $600 billion

Monetary Policy and the Multiplier

Aggregate Demand  The Fed’s objective of stimulating the economy is achieved in three steps: l An increase in the money supply. l A reduction in interest rates. l An increase in aggregate demand.

Monetary Stimulus An increase in the money supply lowers the rate of interest g1g1 g2g2 Quantity Of Money Interest Rate Demand for money E1E1 E2E2 A reduction in the rate of interest stimulates investment Interest Rate 7 6 I1I1 I2I2 Rate Of Investment 0 Investment demand More investment increases aggregate demand (including multiplier effects) Price Level Income (Output) AD 1 AD 2 AS

The Short-Run Determination of the Interest Rate

Can you walk through how contractionary monetary policy plays out? Fed shrinks the money supply and…

Federal Reserve Policy and the Business Cycle