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Expansionary Monetary Policy in a Recessionary Gap

If the Fed engages in expansionary monetary policy to combat a recessionary gap, the increase in the money

supply will lower the interest rate. The lower interest rate reduces the cost of borrowing and the return to saving. Therefore, firms invest in new plant and equip-ment, while households increase their investment in housing at the lower interest rate. In short, when the Fed increases the money supply, interest rates fall and the quantity demanded of goods and services increases at each and every price level. The aggregate demand curve shifts from AD1 to AD2, as seen in Exhibit 1. The result is greater RGDP growth at a higher price

level at E2. In this case, the Fed has eliminated the recession, and RGDP is equal to the potential level of output at RGDPNR. During the recession of 2001, the Fed aggressively lowered the federal funds rate to stimulate aggregate demand when it was faced with a recessionary gap.

For example, in the first half of 2001, the Fed slashed interest rates to their lowest levels since August 1994. Between January 2001 and August 2001, the Fed cut the federal funds rate target by 3 percentage points, clearly demonstrating that it was concerned that the economy was dangerously close to falling into a recession. Then came the events of September 11 and the corporate scandals. By the end of the year, the federal funds rate, which began at 6.5 percent, was at 1.75 percent, the lowest rate since 1961. With the slow recovery, the Fed pushed the rate down further, to 1.25 percent in November 2002. The Fed’s actions were aimed at increasing consumer confidence, restoring stock market wealth, and stimulating investment. That is, the Fed’s move was designed to increase aggregate demand in an effort to increase output and employ-ment to long-run equilibrium at E2.

Contractionary Monetary Policy in an Inflationary Gap

The Fed may engage in contractionary monetary policy if the economy faces an inflationary gap.

Suppose the economy is at initial short-run equilib-rium, E1, in Exhibit 2. In order to combat inflation, suppose the Fed engages in an open market sale of bonds. This would lead to a decrease in the money supply, causing the interest rate to rise. The higher interest rate means that borrowing is more expensive and the return to saving is higher. Consequently, firms find it more costly to invest in plant and equipment and households find it more costly to finance new homes. In short, when the Fed decreases the money

n What is expansionary monetary policy?

n What is contractionary monetary policy?

n How does monetary policy work in the open economy?

n How does monetary policy impact real GDP and the price level?

Expansionary and Contractionary Monetary Policy

Expansionary Monetary Policy in a Recessionary Gap

Pri

ce L

evel

Real GDP(trillions of dollars)

0RGDPNRRGDP1

PL2

PL1

LRASSRAS

AD2

E1

E2

AD1

An increase in ADdue 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 AD1 to AD2. 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 5 potential GDP).

848 PART 8 Macroeconomic Policy

S e c t i o n

28.4

section 28.4exhibit 1

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# 102882 Cust: Cengage Learning Au: Sexton Pg. No. 850 Title: Exploring Economics: Pathways to Problem Solving Server: _____

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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 AD1 to AD2 in Exhibit 2. The result is a lower RGDP and a lower price level, at E2. The economy is now at RGDPNR where RGDP equals the potential level of output.

Monetary Policy in the Open Economy

For 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

Pri

ce L

evel

Real GDP(trillions of dollars)

0RGDPNR RGDP1

PL2

PL1

LRAS

SRAS

AD2

E1

E2

AD1

A decrease in ADdue to contractionary

monetary policy

If the Fed is combatting an inflationary gap at E1, it can decrease the money supply, which would lead to a change from AD1 to AD2. The result is a lower RGDP and a lower price level at E2, and the economy moves to the natural rate (where RGDP 5 potential GDP).

QDuring 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?

AThe 1929 economy was at PL1929 and RGDPNR 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 AD1929 to AD1932, real GDP fell to RGDP1932, and the price level fell to PL1932.

Money and the ad/aS Model

The Great Depression

Pri

ce L

evel

Real GDP

0RGDP1932 RGDPNR

PL1932

PL1929

LRASSRAS

AD1932

AD1929

850 PART 8 Macroeconomic Policy

section 28.4exhibit 2

section 28.4exhibit 3

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