CHAPTER 15 MONETARY POLICY

Monetary Policy, Real GDP, and the Price Level

We have explained how the Fed can change the money supply

Now we need to link up: The money supply The interest rate Investment spending Aggregate demand

This lets us see how monetary policy affects the economy

Monetary Policy, Real GDP, and the Price Level

Monetary Policy, Real GDP, and the Price Level

A cause-effect chain: Demand for money is comprised of two

parts: Transaction Demand is directly related to GDP Asset demand is inversely related to interest

rates, so total money demand is inversely related to interest rates.

MONETARY POLICY, REAL GDP,AND THE PRICE LEVEL

Cause-Effect Chain• Money supply impacts

interest rates• Interest rates affect

investment• Investment is a

component of AD• Equilibrium GDP is

changed

Real domestic output, GDP

Dm

InvestmentDemand

Real

rat

e of

inte

rest

, i

10

8

6

0Quantity of money demanded and supplied Amount of investment, i

MONETARY POLICY AND EQUILIBRIUM GDPSm1

AS

AD1(I=$15)

P1

10

8

6

0

Sm2

AD3(I=$25)

P2

If the Money SupplyIncreases to Stimulatethe Economy…Interest Rate DecreasesInvestment IncreasesAD & GDP Increases with slight inflationPr

ice

leve

l

AD2(I=$20)

P3

Sm3

Increasing money supply continues the growth – but, watch Price Level.

Monetary Policy, Real GDP, and the Price Level

Supply of money is assumed to be set by the Fed

Interaction of supply and demand determines the market rate of interest (Figure 15-2a)

Interest rate determines amount of investment business will be willing to make

Investment demand is inversely related to interest rates (Figure 15-2b)

Chapter 15 Figure 15.2(a)

Chapter 15 Figure

15.2(b)

Monetary Policy, Real GDP, and the Price Level

Effect of interest rate changes on level of investment is great because interest cost of large, long-term investment is a sizable part of investment cost.

As investment rises or falls, equilibrium GDP rises or falls by a multiple amount. (Figure 15-2c)

Chapter 15 Figure 15.2(c)

Expansionary or Easy Money Policy

The Fed takes steps to increase excess reserves, which lowers the interest rate and increases investment which, in turn, increases GDP by a multiple amount

Contractionary or Tight Money Policy

Excess reserves fall, which raises interest rate, which decreases investment, which, in turn, decreases GDP by a multiple amount of the change in investment

Chapter 15 Table 15.3