Monetary Policy and Interest Rates

Expansionary Policy The Federal Reserve tries to reduce unemployment by: – Buying bonds (open market transactions) – Lowering the Discount Rate – Lowering the reserve rate

Contractionary Policy The Federal Reserve tries to reduce inflation by: – Selling bonds (open market transactions) – Increasing the Discount Rate – Increasing the reserve rate

Money Market

Expansionary Monetary Policy Chain of Events: 1.The Fed observes that the economy is in a recessionary gap. 2.The Fed increases the money supply. 3.The interest rate falls. 4.Investment and consumption increase. 5.AD shifts to the right. 6.Real GDP increases, unemployment rate decreases, the aggregate price level rises.

Figure 32.2 The Long-Run Determination of the Interest Rate Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Contractionary Monetary Policy Chain of Events: 1.The Fed observes that the economy is in a inflationary gap. 2.The Fed decreases the money supply. 3.The interest rate increases. 4.Investment and consumption decrease. 5.AD shifts to the left. 6.Real GDP decreases, unemployment rate increases, the aggregate price level falls.

Putting it all together… Suppose the economy is currently suffering from a very high rate of inflation caused by aggregate demand that has increased beyond potential GDP. a.In a correctly labeled graph, show equilibrium in the money market. b.In a correctly labeled AD/AS graph, show the current short-run equilibrium in the macroeconomy. c.In response to this high inflation rate, should the Fed engage in expansionary or contractionary monetary policy? d.In your graph from part a), show the impact of this monetary policy in the money market and on the equilibrium interest rate. e.In your graph from part b), show the impact of this monetary policy on real GDP and the price level.

Initial Graphs LRAS SRAS AD Real GDP Agg. Price Level E P1P1 Y1Y1 YPYP MS r1r1 M1M1 0 0

After Contractionary Policy LRAS SRAS AD Real GDP Agg. Price Level E P1P1 Y1Y1 YPYP MS 1 r1r1 M1M1 MS 2 r2r2 M2M2 AD 2 P2P2 E2E2 0 0