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Monetary and Fiscal Policy
Monetary Policy: The Mainstream
Monetary Policy Using the AD/AS Model
Page 1 of 2
We’ve discussed how the classical economists believe that money was neutral, that is, changes in the money supply
in the long run have no affect on the real economy. Let’s see if we can recreate that result now in our model of the
macroeconomy. Let’s look at how we would represent monetary policy using the aggregate demand and aggregate
supply curves and see if, in fact, money can make a difference in the short run or the long run and what that
conclusion depends on.
So we’re considering here monetary policy, which means we’re going to be shifting the aggregate demand curve. An
increase in the money supply is going to lower interest rates, and therefore, shift the aggregate demand curve
outwards as businesses do more investment spending at lower interest rates. A decrease in the money supply, on
the other hand, is going to raise interest rates and, therefore, shift the aggregate demand curve inwards as
businesses do less investment spending at the higher interest rates. So monetary policy is shown in the picture as a
shift in the aggregate demand curve, but what is monetary policy? What actions are going to accomplish this shift?
First, there are changes in the reserve requirement. If the Federal Reserve lowered the reserve requirement on
commercial banks, banks can create more checking accounts and therefore, more loans for a given quantity of
reserves. That increases the money supply and lowers the interest rate and shifts out the aggregate demand curve.
The second policy tool is the open market operation. If the Federal Reserve buys government securities, it puts
money into circulation as it takes the securities into its own vault. This increase in reserves in the form of the Fed
paying for securities with checks is going to increase the number of loans that banks can make and therefore,
increase the money supply and shift the aggregate demand curve outwards. And finally, if the Federal Reserve
lowers the discount rate or makes more discount loans, they’re going to be pumping reserves into the banking system
and increasing the money supply shifting out the aggregate demand curve. So a decrease in the reserve
requirement, open market purchases of securities and lowering the discount rate and increasing discount loans, all
shift out the aggregate demand curve. We call this expansionary monetary policy because the economy is going to
expand as a result of the increase in the money supply. Let’s show how this works now in our diagram.
The increased money supply shifts out the aggregate demand curve from AD0 to AD1. In the short run now, we’re
going to have a period of adjustment, that is, at the original price level, P0, in our original long-run macroeconomic
equilibrium, we have excess demand in the markets, that is, people want to buy more goods and services than the
economy is creating. If you look at the difference here between the price as it touches the blue curve and the price as
it touches the new red aggregate demand curve. This means that there’s going to be a shortage of goods and
services and upward pressure on the price level. So as the price level increases then, the demand for money
increases, interest rates rise and businesses cut back some on their investment spending. At the same time,
consumers buy less because of the wealth affects and foreigners buy less because of our goods being relatively
expensive. As the price level rises, businesses produce more in the short run until we get to this new point right here
with a price level of P1 and higher output level of Y1. So in my diagram here, I'm going to have this adjustment in the
short run. Now as long as the short run persists, we get expansion of the economy, that is, the increase in the money
supply by lowering the interest rate relative to what it originally was has stimulated business spending and therefore,
increased demand and increased production and the economy has grown and with it employment. Prices are also up
a bit compared to where they were before. However, this situation is unsustainable and you can see why. We’re
above full employment, we’re driving faster than the speed limit of the economy and, therefore, there’s going to be
upward pressure on prices as businesses compete more aggressively to hire workers and get raw materials. So what
happens as the price level rises is businesses begin to pass these increased costs onto their customers in the form of
higher prices for goods and services. So the short-run aggregate supply curve begins to shift upward. So the
economy moves along the aggregate demand curve as the short-run supply curve keeps shifting upwards until finally
we get to a new long-run equilibrium with this short-run supply curve, the short-run aggregate supply curve which I've
labeled with infinity because this is the end of our adjustment process.
So what’s changed relative to the initial situation? The money supply increased which stimulated business spending,
but it caused the economy to overheat and with it rising prices. As the short-run aggregate supply curve shifted
upwards, the price level continued to rise until it reached its new long-run equilibrium level and we’re going to call that
new long-run equilibrium level P infinity. This higher price level is the consequence of the increased money supply.
Monetary and Fiscal Policy
Monetary Policy: The Mainstream
Monetary Policy Using the AD/AS Model
Page 2 of 2
Well, what’s changed in this economy? Well, what’s changed, in fact, is very little. The result of the increased money
supply is that the price level is higher. But the economist isn’t especially interested in that. We want to know what
affect does this price level have on everyone else in the economy. Has it actually changed anything?
Well, let’s see. Output hasn’t changed because in long-run equilibrium, we return to full employment so output is
exactly the same as it was before. So to that extent, money increases have had no long-run consequence on output
and therefore, they haven’t permanently expanded the economy. Well, what has changed? Has business spending
changed? Well, perhaps not. Certainly government spending hasn’t changed because it’s completely autonomous.
Our price level is higher than it was before, so foreigners may be deterred from buying our goods and services and if
foreigners are deterred from buying our goods and services, then who’s made up the slack? Well, consumers are
probably also deterred because their savings accounts are shrinking in purchasing power because prices are higher.
So if foreigners and consumers are buying less, who's buying more? The government is buying the same as it was
before. It must be that businesses are buying more. It must be that the expansion in the money supply has lowered
interest rates enough that businesses step in and buy more goods and services. Perhaps that’s the thing that’s
changed in this model. Nothing else has changed. It may be that there’s a slight change in the composition of
spending with businesses purchasing more of the goods and services and consumers and foreigners purchasing less.
But in the end we have exactly the same output as we had before. The price level is higher and there have been no
other real consequences in the economy. That’s what the classical economists mean whenever they say that money
is neutral.
Well, that’s expansionary monetary policy. We could now draw the other picture, have the aggregate demand curve
shift inwards as the money supply is reduced. The Federal Reserve would tighten the money supply by raising the
reserve requirement or raising the discount rate or doing open market sales of security, taking money into their vaults
and putting securities out into the market. In that case the interest rate will rise and businesses want to spend less
and you get exactly the opposite adjustment process. The economy is below full employment, the price level falls and
the short-run aggregate supply curve shifts outwards until we get a new intersection at a lower price level. Once
again, no change in the long run in output and employment in the economy. The only changes might possibly be in
the composition, that is, the relative, quantities of output purchased by households and foreigners on one hand and
businesses on the other.
So from the point of view then, of the model we’ve been developing, it does look like money is neutral, that is, money
might in the short run have an affect on output, but not in the long run except as far as who’s buying it depending on
how prices influence people’s behavior.
Now this brings up a question, which is does monetary policy make any difference at all? And that depends on how
quickly the supply curve moves from its original position to its new long-run equilibrium position and that’s going to
depend on how quickly people figure out what’s going on. That’s the rate at which their expectations adjust to the new
environment and the rate at which contracts like labor union contracts for wages and fixed prices that are in menus,
the rate at which those things can change. If they can change rapidly to incorporate people’s expectations about
inflation, then the blue curve might move very quickly and we might not spend much time at all at this point of
expanded output. We might instead move very quickly up to this new point. If expectations are completely rational
and there are not institutional constraints like contracts, then we’re going to go directly up to the new long-run
equilibrium. There’s no affect at all. Output never increases and monetary policy has no affect at all as far as
expanding the economy. We just stay where we were.
So there you have it. Money is neutral in the long run and we get to the long run faster if expectations are rational and
there are few contractual constraints on the economy. The economy expands when the Fed increases the money
supply, it contracts when the Fed decreases the money supply, but the extent to which those expansions and
contractions actually change output, depend on the speed with which people adjust to the change in the economy.