Monetary Policy and Interest
Rates
Expansionary Policy
• The Federal Reserve tries to reduce
unemployment by:
– Buying bonds (open market transactions)
– Lowering the Discount Rate
– Lowering the reserve rate
Contractionary Policy
• The Federal Reserve tries to reduce inflation
by:
– Selling bonds (open market transactions)
– Increasing the Discount Rate
– Increasing the reserve rate
Money Market
Expansionary Monetary Policy
Chain of Events:
1. The Fed observes that the economy is in a
recessionary gap.
2. The Fed increases the money supply.
3. The interest rate falls.
4. Investment and consumption increase.
5. AD shifts to the right.
6. Real GDP increases, unemployment rate
decreases, the aggregate price level rises.
Figure 32.2 The Long-Run Determination of the Interest Rate
Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition
Copyright © 2011 by Worth Publishers
Contractionary Monetary Policy
Chain of Events:
1. The Fed observes that the economy is in a
inflationary gap.
2. The Fed decreases the money supply.
3. The interest rate increases.
4. Investment and consumption decrease.
5. AD shifts to the left.
6. Real GDP decreases, unemployment rate
increases, the aggregate price level falls.
Putting it all together…
Suppose the economy is currently suffering from a very high rate of
inflation caused by aggregate demand that has increased beyond
potential GDP.
a. In a correctly labeled graph, show equilibrium in the money
market.
b. In a correctly labeled AD/AS graph, show the current short-run
equilibrium in the macroeconomy.
c. In response to this high inflation rate, should the Fed engage in
expansionary or contractionary monetary policy?
d. In your graph from part a), show the impact of this monetary
policy in the money market and on the equilibrium interest rate.
e. In your graph from part b), show the impact of this monetary
policy on real GDP and the price level.
Initial Graphs
Agg.
Price
Level
MS
LRAS
AD
SRAS
E
P1
r1
0
M1
0
YP
Y1
Real GDP
After Contractionary Policy
MS2
MS1
Agg.
Price
Level
LRAS
AD
SRAS
AD2
E
P1
P2
r2
E2
r1
0
M2
M1
0
YP
Y1
Real GDP