Monetary Policy & Aggregate Demand

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. M i I P0 Price level P1 AD0 AD1 Y1 Y0 Real output Contractionary Monetary Policy in the AS/AD Model* Y Short-run aggregate supply

9. M i I Y Expansionary Monetary Policy* P1 Price level P0 AD1 AD0 Y0 Y1 Real output

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. Wages, rents, interest, profits Government expenditures Taxes Consumptio Government fiscal policy Firms Government borrowing Households Expenditures Investment Savings Financial sector Exports Monetary policy Imports Consumption 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 Direct impact of increase Investment spending + $200 billion Indirect impact via increased consumption + $600 billion a Price Level (average price) b Current price level P1 AD2 AD3 AD1 5.8 Real GDP ($ trillions per year) 5.6 QE 6.4

19. Monetary Policy and the Multiplier

20. Aggregate Demand • The Fed’s objective of stimulating the economy is achieved in three steps: • An increase in the money supply. • A reduction in interest rates. • An increase in aggregate demand.

21. An increase in the money supply lowers the rate of interest A reduction in the rate of interest stimulates investment More investment increases aggregate demand (including multiplier effects) AS Investment demand E1 7 7 Interest Rate Interest Rate Price Level Demand for money 6 6 E2 AD2 AD1 0 0 g1 g2 I1 I2 Quantity Of Money Rate Of Investment Income (Output) Monetary Stimulus

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