Unformatted text preview: higher investment and consumer spending as well as a rise in aggregate demand. Monetary policy that increases aggregate demand is called expansionary
monetary policy. Figure M O N E TA R Y P O L I C Y 355 Expansionary monetary policy is monetary policy that increases aggregate
demand. 148 Expansionary Monetary Policy
to Fight a Recessionary Gap
Here, initial actual aggregate output, Y1, is
below potential output, YE. An expansionary
monetary policy reduces the interest rate,
shifting the aggregate demand curve rightward from AD1 to AD2 and eliminating the
recessionary gap. Aggregate
price
level LRAS
SRAS E2
P2
P1 An expansionary monetary
policy reduces the interest
rate and increases
aggregate demand. E1 AD1
Y1 YE AD2 Potential
output Real GDP Recessionary gap Contractionary monetary policy is
monetary policy that reduces aggregate
demand. Robert Mankoff/Cartoonbank.com Figure 149 on page 356 shows the opposite case—an economy facing an inflationary gap, where actual output is above
potential output. SRAS is the shortrun aggregate supply curve,
LRAS is the longrun aggregate supply curve, and AD1 is the initial aggregate demand curve. At the initial shortrun macroeconomic equilibrium, aggregate output, Y1, is above potential
output, YE. As we’ll explain in later chapters, policy makers
often try to head off inflation by eliminating inflationary gaps.
To eliminate the inflationary gap illustrated in Figure 149, aggregate demand must be reduced. By raising the interest rate,
the Fed can cause a leftward shift of the aggregate demand
curve, from AD1 to AD2, which reduces aggregate output to potential output. Monetary policy that reduces aggregate demand
is called contractionary monetary policy.
Does monetary policy, like fiscal policy, have a multiplier effect
on aggregate demand? Yes, although it’s important to have a clear
understanding of what is being multiplied. “I told you the Fed should have tightened.” 356 PA R T 5 S H O R T R U N E C O N O M I C F L U C T U AT I O N S Figure UNCORRECTED Preliminary Edition 149 Contractionary Monetary Policy
to Fight an Inflationary Gap Aggregate
price
level LRAS
SRAS Here, initial actual aggregate output, Y1, is
above potential output, YE. A contractionary
monetary policy increases the interest rate,
shifting the aggregate demand curve leftward from AD1 to AD2 and eliminating the
inflationary gap. E1 P1 A contractionary monetary
policy increases the interest
rate and reduces
aggregate demand. P2
E2 AD1 AD2
Potential
output YE Y1 Real GDP Inflationary gap Monetary Policy and the Multiplier
Suppose the Fed drives down the interest rate, causing a rightward shift of the aggregate demand curve. How expansionary is this? That is, how much does the AD curve
shift to the right? We’ll use the multiplier analysis of Chapter 10 to answer that question. In particular, we’ll analyze how monetary policy, via a change in the interest
rate, affects aggregate demand. (For the purposes of this analysis, we’ll ignore the effect of taxes on the multip...
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 Spring '09
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 Inflation, Interest Rates, Monetary Policy, federal funds rate

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