Monetary Policy and Interest Rates

Expansionary Policy

• The Federal Reserve tries to reduce unemployment by:– Buying bonds (open market transactions)– Lowering the Discount Rate– Lowering the reserve rate

Contractionary Policy

• The Federal Reserve tries to reduce inflation by:– Selling bonds (open market transactions)– Increasing the Discount Rate– Increasing the reserve rate

Money Market

Expansionary Monetary Policy

Chain of Events:1. The Fed observes that the economy is in a

recessionary gap. 2. The Fed increases the money supply. 3. The interest rate falls. 4. Investment and consumption increase. 5. AD shifts to the right. 6. Real GDP increases, unemployment rate

decreases, the aggregate price level rises.

Figure 32.2 The Long-Run Determination of the Interest RateRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

Contractionary Monetary Policy

Chain of Events:1. The Fed observes that the economy is in a

inflationary gap. 2. The Fed decreases the money supply. 3. The interest rate increases. 4. Investment and consumption decrease. 5. AD shifts to the left. 6. Real GDP decreases, unemployment rate

increases, the aggregate price level falls.

Putting it all together…Suppose the economy is currently suffering from a very high rate of inflation caused by aggregate demand that has increased beyond potential GDP.a. In a correctly labeled graph, show equilibrium in the money

market.b. In a correctly labeled AD/AS graph, show the current short-run

equilibrium in the macroeconomy.c. In response to this high inflation rate, should the Fed engage in

expansionary or contractionary monetary policy?d. In your graph from part a), show the impact of this monetary

policy in the money market and on the equilibrium interest rate.e. In your graph from part b), show the impact of this monetary

policy on real GDP and the price level.

Initial Graphs

LRAS

SRASAD

Real GDP

Agg.PriceLevel

EP1

Y1YP

MS

r1

M10

0

After Contractionary Policy

LRAS

SRASAD

Real GDP

Agg.PriceLevel

EP1

Y1YP

MS1

r1

M1

MS2

r2

M2

AD2

P2

E2

00