Expansionary and Contractionary Monetary Policy: Videos & Practice Problems

Understanding the relationship between the money market and the Aggregate Demand-Aggregate Supply (ADAS) model is crucial for grasping how monetary policy influences the economy. The Federal Reserve (Fed) aims to achieve two primary objectives: maximizing employment and ensuring price stability. During a recession, when real GDP falls below its potential output, the economy experiences cyclical unemployment and reduced investment, leading to a decline in aggregate demand.

To combat this, the Fed implements expansionary monetary policy, which seeks to stimulate economic growth by increasing GDP. A key strategy in this approach is to lower interest rates, making borrowing cheaper for businesses and encouraging investment. This is achieved by increasing the money supply in the economy. In the money market, the interest rate is plotted on the vertical axis, while the quantity of money is on the horizontal axis. Initially, the equilibrium interest rate is at a higher level (r₁), but to stimulate the economy, the Fed aims to lower it to r₂.

To lower the interest rate, the Fed increases the money supply by purchasing treasury securities from the public. This action injects more money into the economy, shifting the money supply curve to the right and resulting in a new equilibrium at the lower interest rate (r₂). The increase in the money supply leads to higher consumption, investment, and net exports, all of which contribute to a rightward shift of the aggregate demand curve.

As aggregate demand increases, the economy moves towards its long-run equilibrium, characterized by a higher level of GDP and a higher price level. This process illustrates how the Fed's actions in the money market directly influence the ADAS model, ultimately aiming to restore the economy to its full potential output.

Conversely, if the Fed decides to implement contractionary monetary policy, the approach would involve decreasing the money supply to raise interest rates, thereby reducing aggregate demand. This would be necessary in situations where inflation is a concern, as higher interest rates typically lead to lower spending and investment, stabilizing prices but potentially increasing unemployment.

In an economy experiencing high inflation, the Federal Reserve (Fed) may implement contractionary monetary policy to reduce the Gross Domestic Product (GDP) to a sustainable level. This situation arises when the economy is "hot," meaning it is operating beyond its potential GDP, leading to overemployment and rising price levels. To combat this, the Fed increases interest rates, which is the opposite of expansionary policy aimed at boosting GDP.

The contractionary monetary policy involves manipulating the money supply to achieve higher interest rates. When the Fed raises interest rates, it makes borrowing more expensive, which discourages investment and consumer spending. This decrease in spending leads to a reduction in aggregate demand, which is crucial for stabilizing the economy. The relationship between interest rates and aggregate demand is significant; as interest rates rise, investment and consumption typically decline, resulting in lower net exports as well.

Graphically, this can be represented using the Aggregate Demand and Aggregate Supply (AD-AS) model. Initially, the economy operates at a short-run equilibrium where the short-run aggregate supply (SRAS) intersects with aggregate demand (AD) above the long-run aggregate supply (LRAS). The Fed's goal is to shift the aggregate demand curve to the left, aligning it with the long-run equilibrium. This shift is achieved by decreasing the money supply, which the Fed accomplishes through open market operations, specifically by selling securities to the public. This action reduces the money supply, leading to higher equilibrium interest rates.

As a result of these changes, the new equilibrium reflects a lower price level and a more sustainable level of GDP. The process illustrates the interconnectedness of monetary policy, interest rates, and aggregate demand, highlighting the Fed's role in maintaining economic stability. Understanding this dynamic is essential for grasping the broader implications of monetary policy on the economy.