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Unformatted text preview: cuss in Chapter 16.
The important lesson, however, is that over the past two decades the Fed’s actual
policy has largely followed our basic analysis of how monetary policy should work. I <<<<<<<<<<<<<<<<<<
>>CHECK YOUR UNDERSTANDING 14-3
1. Suppose the economy is currently suffering from a recessionary gap and the Federal Reserve
uses an expansionary monetary policy to close that gap. Describe the short-run effect of this
policy on the following:
a. The money supply curve
b. The equilibrium interest rate
c. Investment spending
d. Consumer spending
e. Aggregate output
f. The aggregate price level
h. The supply of loanable funds in the loanable funds market
Solutions appear at back of book. Money, Output, and Prices in the Long Run
Through its expansionary and contractionary effects, monetary policy can be used to
move the economy more quickly to long-run macroeconomic equilibrium. Sometimes, however, there are monetary events that move the economy away from longrun macroeconomic equilibrium. Sometimes the central bank simply makes a
mistake. For example, it may believe that potential output is higher or lower than it
really is and implement a misguided monetary policy. In addition, central banks are
sometimes forced to pursue considerations other than stabilizing the economy. For
example, as we’ll see in Chapter 16, central banks sometimes help the government
pay its bills by printing money, an action that increases the money supply.
What happens when a change in the money supply pushes the economy away
from, rather than toward, long-run equilibrium? We learned in Chapter 10 that the
economy is self-correcting in the long run: a demand shock has only a temporary effect on aggregate output. If the demand shock is the result of a change in the money
supply, we can make a stronger statement: in the long run, changes in the quantity of
money affect the aggregate price level, but they do not change aggregate output or the
interest rate. To see why, let’s look at the case of an increase in the money supply. Short-Run and Long-Run Effects of an Increase in the
To analyze the long-run effects of an increase in the quantity of money, we need to recall the distinction between the short-run and long-run aggregate supply curves. The
short-run aggregate supply curve slopes upward: in the short run, a higher aggregate
price level leads to higher production. The long-run aggregate supply curve, however, is
vertical at potential output: in the long run, a rise in prices of final goods and services
leads to an equal rise in factor prices, and output remains equal to potential output.
Figure 14-13 shows the short-run and long-run effects of an increase in the
money supply when the economy begins at potential output, Y1. The initial short-run
aggregate supply curve is SRAS1, the long-run aggregate supply curve is LRAS, and the
initial aggregate demand curve is AD1. The economy’s initial equilibrium is at E1, a
point of both short-run and long-run macroeconomic equilibrium because it is on UNCORRECTED Prelimi...
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This note was uploaded on 09/09/2009 for the course ECON 701 taught by Professor Charlie during the Spring '09 term at École Normale Supérieure.
- Spring '09
- Monetary Policy