KRUGMAN_WELLS_MACRO_CHAPTER14

Figure m o n e ta r y p o l i c y 355 expansionary

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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. 14-8 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 14-9 on page 356 shows the opposite case—an economy facing an inflationary gap, where actual output is above potential output. SRAS is the short-run aggregate supply curve, LRAS is the long-run aggregate supply curve, and AD1 is the initial aggregate demand curve. At the initial short-run 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 14-9, 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 14-9 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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