1. Monetary Policy & Aggregate Demand Chapter 14-3

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

3. Expansionary Monetary Policy to Fight a Recessionary Gap

4. Contractionary Monetary Policy to Fight an Inflationary Gap

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

6. 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.

7. 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.

8. 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

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

10. 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

11. Monetary Policy in the Circular Flow

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

13. 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.

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

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

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

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

18. Multiplier Effects Real GDP ($ trillions per year) Price Level (average price) P1P1 5.6 QEQE 5.8 6.4 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

19. Monetary Policy and the Multiplier

20. 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.

21. Monetary Stimulus An increase in the money supply lowers the rate of interest g1g1 g2g2 Quantity Of Money Interest Rate 7 6 0 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

22. The Short-Run Determination of the Interest Rate

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

24. Federal Reserve Policy and the Business Cycle