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PART 8 Macroeconomic Policy
Expansionary and Contractionary
Monetary Policy
Section
28.4
n What is expansionary monetary policy?
n What is contractionary monetary policy?
n How does monetary policy work in the
n How does monetary policy impact real
GDP and the price level?
open economy?
Expansionary Monetary Policy
in a Recessionary Gap
I
f 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 equipment, 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
section 28.4
exhibit 1
Expansionary Monetary Policy
in a Recessionary Gap
An increase in AD
due to expansionary
monetary policy
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 employment to long-run equilibrium at E2.
LRAS
Price Level
SRAS
PL2
PL1
E1
AD1
0
Contractionary Monetary
Policy in an Inflationary Gap
E2
RGDP1
AD2
RGDPNR
Real GDP
(trillions of dollars)
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 expansionary monetary policy has moved the economy to the
natural rate (where RGDP 5 potential GDP).
T
he Fed may engage in contractionary monetary
policy if the economy faces an inflationary gap.
Suppose the economy is at initial short-run equilibrium, 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
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PART 8 Macroeconomic Policy
section 28.4
exhibit 2
Contractionary Monetary Policy
in an Inflationary Gap
LRAS
Price Level
SRAS
PL1
PL2
E1
E2
A decrease in AD
due to contractionary
monetary policy
AD1
0
AD2
RGDPNR RGDP1
Real GDP
(trillions of dollars)
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).
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
F
or 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 dollars for foreign currency, which leads to a depreciation
Money and the AD /AS Model
section 28.4
exhibit 3
A
The 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 investment 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.
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The Great Depression
LRAS
SRAS
PL1929
Price Level
Q
During the Great Depression in the United
States, the price level fell, the money wage rate fell,
real GDP fell, and unemployment reached 25 percent. 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?
PL1932
AD1932
0
RGDP1932
AD1929
RGDPNR
Real GDP
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