What is expansionary monetary policy? - PDF document

�, What is expansionary monetary policy? �, What is contractionary monetary policy? �, How does monetary policy work in the open economy? �, How does monetary policy impact real GDP and the price level? Expansionary and Contractionary Monetary Policy Expansionary Monetary Policy in a Recessionary Gap Price Level Real GDP (trillions of dollars) 0 RGDP NR RGDP 1 PL 2 PL 1 LRAS SRA S AD 2 E 1 E 2 AD 1 An increase in AD due to expansionary monetary policy If the Fed is combatting a recessionary gap, it can increase the money supply, which leads to a change in aggregate demand from AD 1 to AD 2 . The result is greater RGDP of a higher price level. The expansion- ary monetary policy has moved the economy to the natural rate (where RGDP � potential GDP). 848 PART 8 Macroeconomic Policy SECTION 28.4 52270_28_ch28_p832-876.indd 848 4/14/10 6:15:52 PM # 102882 Cust: Cengage Learning Au: Sexton Pg. No. 850 Title: Exploring Economics: Pathways to Problem Solving Server: _____ C / M / Y /K Short / Normal / Long DESIGN SERVICES OF S4-CARLISLE Publishing Services supply it raises the interest rate and decreases the quantity of goods and services demanded at every price level. That is, the aggregate demand curve shifts leftward from AD 1 to AD 2 in Exhibit 2. The result is a lower RGDP and a lower price level, at E 2 . The economy is now at RGDP NR where RGDP equals the potential level of output. Monetary Policy in the Open Economy F or simplicity, we have assumed that the global economy does not affect domestic monetary policy. This assumption is incorrect. Suppose the Fed decides to pursue an expansionary policy by buying bonds on the open market. As we have seen, when the Fed buys bonds on the open market, the immediate effect is that the money supply increases and interest rates fall. With lower domestic interest rates, some domestic investors will invest funds in foreign markets, exchanging dol- lars for foreign currency, which leads to a depreciation Contractionary Monetary Policy in an Inflationary Gap Price Level Real GDP (trillions of dollars) 0 RGDP NR RGDP 1 PL 2 PL 1 LRAS SRAS AD 2 E 1 E 2 AD 1 A decrease in AD due to contractionary monetary policy If the Fed is combatting an inflationary gap at E 1 , it can decrease the money supply, which would lead to a change from AD 1 to AD 2 . The result is a lower RGDP and a lower price level at E 2 , and the economy moves to the natural rate (where RGDP � potential GDP). Q During the Great Depression in the United States, the price level fell, the money wage rate fell, real GDP fell, and unemployment reached 25 per- cent. Investment fell, and as banks failed, the money supply fell dramatically. Can you show the effect of these changes from a vibrant 1929 economy to a battered 1932 economy using the AD / AS model? A The 1929 economy was at PL 1929 and RGDP NR in Exhibit 3. The lack of consumer confidence coupled with the large reduction in the money supply, wealth lost in the stock market crash, and falling invest- ment sent the aggregate demand curve reeling. As a result, the aggregate demand curve fell from AD 1929 to AD 1932 , real GDP fell to RGDP 1932 , and the price level fell to PL 1932 . MONEY AND THE AD / A S MODEL The Great Depression Price Level Real GDP 0 RGDP 1932 RGDP NR PL 1932 PL 1929 LRAS SRAS AD 1932 AD 1929 850 PART 8 Macroeconomic Policy 52270_28_ch28_p832-876.indd 850 4/14/10 7:11:55 PM