Download Monetary Policy and the Interest Rate

Inflation, Unemployment,
and Stabilization Policies:
Monetary Policy and the
Interest Rate
AP Economics
Mr. Bordelon
Monetary Policy and the Interest Rate
Monetary Policy and
the Interest Rate
Use the money market model to
explain how the Fed uses
monetary policy to stabilize the
economy in the short run.
Remember, this is the nominal
interest rate here.
Fed increases MS through openmarket operations to buy T-bills
from large commercial banks.
The increase in MS causes
nominal interest rates to
decrease.
Monetary Policy and
the Interest Rate
Fed decreases MS through open
market operations, selling T-bills
to large commercial banks.
Decrease in MS causes nominal
interest rates to increase.
Monetary Policy and the Interest Rate
The Fed adjusts the money supply to target a specific
federal funds rate.
If current federal funds rate is higher than target, Fed
will increase MS so that rate decreases to target.
If current federal funds rate is lower than target, Fed
will decrease MS so that rate increases to target.
Expansionary and Contractionary Monetary Policy
Investment spending is sensitive to changes in the
interest rate. When interest rates decrease, investment
spending increases.
Some types of consumption spending also increases
when the interest rates decrease (car/truck buying,
college educations, real estate).
Investment spending and consumption spending are
important components of AD.
When interest rate decreases, AD should increase.
Expansionary and Contractionary Monetary Policy
Expansionary Monetary Policy
Fed sees the economy is in a recessionary gap.
Fed increases MS.
Interest rate decreases.
Investment and consumption increase.
AD increases (shifts right).
Real GDP increases, unemployment rate decreases, APL
increases.
Expansionary and Contractionary Monetary Policy
Contractionary Monetary Policy
Fed sees the economy is in an inflationary gap.
Fed decreases MS.
Interest rate increases.
Investment and consumption decrease.
AD decreases (shifts left).
Real GDP decreases, unemployment rate increases, APL
decreases.
Question 1
Suppose the economy is currently suffering from a very high rate of inflation
caused by aggregate demand that has increased beyond potential GDP.
In a correctly labeled graph, show equilibrium in the money market.
In a correctly labeled AD/AS graph, show the current short-run equilibrium
in the macroeconomy.
In response to this high inflation rate, should the Fed engage in expansionary
or contractionary fiscal policy?
In your graph from the first part, show the impact of this monetary policy in
the money market and on the equilibrium interest rate.
In your graph from the second part, show the impact of this monetary policy
on real GDP and the price level.