Expansionary and Contractionary Monetary Policy
Expansionary Monetary Policy
Was this helpful?
So let's continue the idea of the relationship between the money market and the aggregate demand curve by including the entire aggregate demand aggregate supply model. This is the A. D. A. S. Model that we learned previously, we're gonna see how the money market affects this model. So remember the Fed has two main goals when it comes to monetary policy. It's managing the employment in the economy, the the level of employment, they want high employment and they want price stability, right? They want they don't want prices to go out of control through high inflation. So when the economy is in recession, real GDP is below its potential output. We're not we're in recession that the spending is low, there's not as much uh GDP happening as we would want. So during this recession we see what cyclical unemployment. So there's a lot of unemployment and there's low investment going on which is affecting aggregate demand, right? This investment aggregate demand is down because there's not investment going on during the recession. So the Fed is going to employ what's called expansionary monetary policy. They want the economy to expand, right expansionary means they want more GDP, they want GDP to increase. So how do they get GDP to increase? They want to entice investment. So how can they entice investment by managing the interest rate? They can lower the interest rate right? If they if they can get a lower interest rate in the economy. Well it's gonna entice businesses to spend money right? There's low interest, they can make investment in long term purchases because they can take out loans at lower lower cost. So let's look at how an expansionary monetary policy looks like in the money market and R. A. D. A. S. Model. So we're in a situation where in recession, right? Let's look at our A. D. A. S. Model and let's label it real quick. So in our A. D. A. S. Model we have our price level and our GDP right, the real GDP on our other access here on our X axis. So let me get out of the way and what do we have here? Which curves are this are are on our graph here, we've got our long run aggregate supply, our short run aggregate supply and our and our aggregate demand curve. Right? There's no short run or long run with the aggregate demand. We just have one curve there so notice what's happening here, our short run equilibrium where the aggregate demand and the short run aggregate supply are lower than our our long run equilibrium GDP, right, what do we have here in the short run, I'm gonna say short run equilibrium is gonna have this lower GDP. Right, lower GDP because we're in a recession, right? The short run equilibrium has this lower amount of G. D. P. And this is the price level currently. So we'll say P one here in this case. And now what does the Fed wanna do the Fed wants to employ expansionary monetary policy, They want to get us back to this higher level of GDP are long run equilibrium level of GDP? So they want to increase um the amount of G. D. P. And like we said they're gonna lower the interest rate to stimulate the economy. Okay. So how are they going to do that? Let's first look into the money market. So remember on the money market we have our interest rate on the Y axis and we've got the quantity of money here on the X. Axis, right? So the interest rate being the price of money and they want to bring the the interest rate down. So right now the money supply is here at M. S. One, the money demand is here and we've got this equilibrium Interest rate right here are one. So they want to bring the the interest rate down, right? They want the interest rate lower to stimulate the economy to increase investment. So they want to bring it down here to R2. What do they have to do in the money supply to get to this new equilibrium interest rate? Do they need to increase or decrease the money supply? They need to increase the money supply right? By having a higher money supply, then we would have a new equilibrium down where we want it at our two. So this new money supply by expanding the money supply, we'll have the new equilibrium at this lower rate. This lower rate right here which is our two, right? So that would be their target is to increase the money supply by that much to lower the interest rate by that much. So, what are they going to do in this case? Do they buy or sell Treasury securities? Remember this is always the case that the Fed is either buying or selling Treasury securities from the public uh to to affect the money supply. So the Fed is giving something to the public and the public is giving something to the Fed here. The Fed is either giving up money or getting money. They want to increase the money supply, right? So they want to increase the money in the hands of the public. So they're gonna give money to the public in this case, and they're going to get securities right? They're gonna purchase the securities. So in this case they're purchasing securities to increase the money supply, which leads to a lower interest rate. Okay, so this is kind of how all of these moving pieces work, right? We're starting with the purchase of securities, which leads to a higher money supply, which leads to a lower interest rate and this lower interest rate. How is it going to affect our A. D. A. S. Model? So, this is the final piece of the puzzle. This is why the Fed did all of this is because they want to affect the A. D. A. S. Model and get us back to our long run GDP equilibrium. So at this lower interest rate, we already said that it's going to affect investment right? There's an increase to investment. But there's also we've seen increases to consumption and net exports as well. All of those are affected by the lower interest rate. Uh the lower interest rate leads to higher consumption, higher investment, higher net exports, all of these moving parts. So the goal of the Fed is to shift the aggregate demand curve. They want the aggregate demand curve to increase, so they're enticing people to spend more money, not just the citizens, but the firms as well, and foreigners as well. So in this case what's gonna happen is the aggregate demand curve is gonna shift to the right, so we're gonna have this shift to the right to this new equilibrium over here, get it across in the middle there and this is our aggregate demand too. So the final piece of the puzzle there, leading to our new long run equilibrium right here. So our long run equilibrium right here, we're now back to our full potential of G. D. P. In our long run equilibrium. But what's happened to the price level at this long run equilibrium, we found that we have a higher price level, right, a higher price level in this uh long run equilibrium. So there's a lot of moving parts there, right. We saw a lot of things happening but it all comes down to what open market operation did the Fed do? How does that affect our money market and the relationship between the level of interest rate and aggregate demand as well? Alright, so now let's see the opposite where the Fed wants to employ a contractionary monetary policy. Let's see it in the
Contractionary Monetary Policy
Was this helpful?
So it may sound weird, but the Fed may also want to decrease GDP and that would be in a situation where we have a lot of inflation, we see a lot of inflation in the economy and we have what's called, the economy is hot in this case we're basically past our long run GDP level and we're producing at a past a place past our potential our potential GDP. How do we do that? Well, it could be a situation here where we have rising inflation pushing us to a point where we're beyond our long run equilibrium. So let's go ahead and see how this happens in periods of rising inflation where the price levels are increasing a lot, there's gonna be over employment. So basically people are gonna have to be working longer hours than they generally would people who wouldn't have jobs are now in the labor force because the economy is so hot that they want to get in on a piece of the action. So we actually have over employment in the economy and we have increasing price levels. So the economy is basically what we say really hot and we're we're experiencing a lot of inflation. So the Fed is gonna go through what's called contractionary monetary policy to get us back to a maintain a level of GDP that's uh sustainable, right? A level A level that that we can sustain in the long run. So the contractionary monetary policy is where the Fed increases interest rates. So this is the opposite of what we just talked about with expansionary, so they're increasing the interest rates to reduce the level of inflation. So when expansionary was more GDP contractionary is to get us to less GDP. Alright, so let's go ahead and label our graphs again. In this case we've got R A D A. S. Model with our price level and our G. D. P. R real GDP here on the graph, let me get out of the way again. And what's going on in this graph is we've got our long run aggregate supply below our short run equilibrium. So over here we've got our short run aggregate supply and our aggregate demand. And look at our short run equilibrium right here right here where the short run aggregate supply and the aggregate demand curve cross were at this level of GDP short run equilibrium GDP that's beyond our sustainable long run aggregate supply, right? So this is this is our potential here and we're past it. We're over employed, we have a lot of inflation leading to this higher level of G. D. P. In the economy. Okay, so the Fed wants to step in and get us back to our long run equilibrium here. They wanna affect the money market the money supply to increase the interest rates to reduce our aggregate demand. So let's go ahead and see how all these puzzle these pieces moved together. So if this was the price one where we started at our short run equilibrium, let's see what happens to that price level through their contractionary policy. So let's go to the money market where the Fed is going to have an impact. So we see interest rates right here on the y axis, and we have the quantity of money on the X axis, our money supply going straight up and down, fixed by the Fed and our money demand right there with the downward demand. We're used to and we've got this original quantity quantity one of money. Now, the Fed wants to increase interest rates. So here's our equilibrium interest rates are one where we started, and they want to get us to a higher interest rate. They want to bring interest rates up to slow down the economy. They're trying to increase the interest rates to slow down the economy, make it less enticing for investors, for consumers, for uh for net exports, right? All of this, we want to be decreasing. So if they want this higher level of interest rate, what are they gonna do in this case, are they going to increase or decrease the money supply? So they want a higher equilibrium. So, do they want the money supply over here? To the left, or a money supply over here to the right, to get a higher equilibrium. They wanted to move to the left. They want to contract the money supply, right? They wanted less money in the money supply leads to a higher interest rate. So money supply to over here money supply one, and we get this higher equilibrium interest rate at our two, right? There are two with a higher equilibrium interest rate. So what does the Fed have to do? What kind of open market operation? So let's think about it. We've got the Fed over here, whoops the Fed and then the public. And in this case the Fed is going to give to the public something and the public is going to give to the Feds something. So in this case the Fed wants to decrease the money supply. So do they want to give money to the public or take money from the public? They want to take money from the public public, right? They want to decrease the money supply. So the money is going from the public to the Fed and the Fed is selling securities to the public for that, right? So the the the public is going to receive securities. So in this case, the Fed cells, Fed sells Fed sells securities, right? They're selling securities to decrease the money supply, which increases the interest rate. So just like we saw the interest rate affecting the aggregate demand before it's still gonna affect it here. Now, at the higher interest rate, what do we see happening? Investment is gonna decrease, right? The firms are gonna invest less because loans cost more money, consumers are gonna spend less at the higher interest rate. They might be enticed to save more money as well as just not take out loans on cars and things like that. And that exports. We also saw decrease based on how this affects foreigners as well. So since all of these components of aggregate demand are decreasing, aggregate demand is going to decrease as well. So this is exactly what they want, they want the Fed wants aggregate demand to decrease to get us to a more stable level of of G. D. P. And a lower price level in the economy. So if this was a D. One on the graph already and we're seeing aggregate demand decrease, we're gonna have a shift to the left. So this shift to the left is going to draw a new line, a new aggregate demand over here. This is where they want the aggregate demand to land over there at our long run equilibrium. So notice we're back to a long run equilibrium here where our short run aggregate supply, our aggregate demand and our long run aggregate supply are all together once again. Okay, so where where are we in this happy little place that we found? We found that the Fed has succeeded in lowering the price level, right? The new equilibrium that we found in the short run and long run here at the green star shape has a lower price level. And that was from this whole process of selling securities to decrease the money supply, which led to a higher equilibrium interest rate and the higher equilibrium interest rate shifted our aggregate demand curve, leading to a lower equilibrium price level. Wow, that's a big domino effect, right? But that's that's all that's going on, is basically thinking of how we're affecting the money supply and what that does to our aggregate demand curve. Okay. And we're just looking for those equilibrium is like we're used to in general. So this can be a little tricky, and it's it's always worth uh studying this in a little more detail, because this is a big topic in this class. Alright, so when you're ready, let's go ahead and move on to.