CHAPTER 15
MONETARY
POLICY
Monetary Policy, Real GDP, and the Price Level
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

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
MONETARY POLICY AND EQUILIBRIUM GDP
Real rate of interest, i
Sm1
Sm2
Sm3
10
10
8
8
6
6
Dm
0
Quantity of money demanded and supplied
AS
Price level
Investment
Demand
0
Amount of investment, i
If the Money Supply
Increases to Stimulate
the Economy…
Interest Rate Decreases
P3
P2
P1
Investment Increases
AD & GDP Increases
with slight inflation
AD3(I=$25)
AD2(I=$20) Increasing money supply
continues the growth –
AD1(I=$15)
but, watch Price Level.
Real domestic output, GDP
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