Dynamic AD-AS Model: Monetary Policy: Videos & Practice Problems

The dynamic Aggregate Demand and Aggregate Supply (ADAS) model illustrates how monetary policy can influence economic conditions, particularly during periods of recession and inflation. In this model, it is essential to understand that all components—long-run aggregate supply, short-run aggregate supply, and aggregate demand—are expected to grow over time. However, if these components do not increase in harmony, the economy may experience either a recession or inflation.

During a recession, the economy operates below its potential Gross Domestic Product (GDP). To stimulate economic activity and increase spending, the Federal Reserve (Fed) implements expansionary monetary policy. This involves lowering interest rates, which encourages both consumers and businesses to borrow and spend more. Lower interest rates make loans more affordable, prompting firms to invest in new projects and homeowners to finance purchases, thereby boosting aggregate demand.

In graphical terms, the initial equilibrium is represented at a specific point where the price level and real GDP intersect. As the Fed lowers interest rates, the long-run aggregate supply and short-run aggregate supply shift to the right, indicating growth. However, if aggregate demand does not increase sufficiently, the economy remains below its potential GDP. The goal of expansionary monetary policy is to shift aggregate demand enough to reach a new equilibrium where all three curves intersect, indicating that the economy has returned to its long-run equilibrium.

In summary, expansionary monetary policy plays a crucial role in addressing recessions by increasing the money supply and lowering interest rates, which in turn stimulates aggregate demand. This process helps the economy recover and align with its potential GDP, ensuring stability and growth in the long run.

In an economy experiencing rising inflation, it indicates that the economy is operating beyond its potential Gross Domestic Product (GDP). This situation arises when aggregate demand has surged excessively, necessitating a reduction in aggregate demand to stabilize the economy. To achieve this, contractionary fiscal policy is implemented, which discourages spending by increasing interest rates. Higher interest rates lead to decreased borrowing by firms and consumers, thereby reducing overall spending and helping to mitigate inflation.

To visualize this scenario, consider a graph where the initial equilibrium is represented at point A, with the long-run aggregate supply (LRAS1), short-run aggregate supply (SRAS1), and aggregate demand (AD1). As aggregate demand increases significantly, it shifts to the right, leading to a new short-run equilibrium at point B. At this point, the economy's output exceeds its potential GDP, resulting in higher prices due to the excessive demand.

To counteract this inflationary pressure, contractionary monetary policy is employed, which shifts the aggregate demand curve to the left, resulting in a new equilibrium at point C. This adjustment brings the economy back to its long-run equilibrium, stabilizing the price level and aligning output with potential GDP. The process illustrates the interconnectedness of fiscal and monetary policies in managing economic fluctuations.