Monetary Policy & Aggregate
Demand
Chapter 14-3


Expansionary monetary policy is
monetary policy that increases
aggregate demand.
Contractionary monetary policy is
monetary policy that reduces aggregate
demand.
Expansionary Monetary Policy to Fight a Recessionary
Gap
Contractionary Monetary Policy to Fight an Inflationary
Gap
Monetary Policy in the AS/AD
Model**
In AS/AD model, monetary policy is
seen working primarily through its effect
on interest rates.
Contractionary Monetary
Policy
The Fed decreases the money supply.
The interest rates go up.
As interest rates go up, the quantity of
investment goes down.
Contractionary Monetary
Policy
As investment goes down,
aggregate demand goes down.
Aggregate equilibrium demand and income go
down by a multiple of decrease in investment.
Contractionary Monetary Policy
in the AS/AD Model*
Price level
M
i
I
Short-run
aggregate
supply
AD0
P0
P1
AD1
Y1
Y0
Real output
Y
Expansionary Monetary Policy*
Price level
M
i
I
P1
P0
AD1
AD0
Y0
Y1
Real output
Y
Monetary Policy in the Circular
Flow*
Expansionary monetary policy tries to
expand the economy by channeling
more saving into investment.
Contractionary monetary policy tries to
reduce inflationary pressures by
restricting demand for consumer loans
and investment
Monetary Policy in the Circular
Flow
Wages, rents, interest, profits
Taxes
Households
Government
borrowing
Government
Consumptio expenditures
Government
fiscal policy
Firms
Investment
Savings
Financial sector
Monetary policy
Consumption
Exports
Imports
Interest Rates and Spending
Changes in interest rates affect
consumer, investor, government, and
net export spending.
Monetary Stimulus
The goal of monetary stimulus is to
increase aggregate demand.
Aggregate Demand – The total quantity of
output demanded at alternative price levels
in a given time period, ceteris paribus.
Monetary Stimulus
The way to increase aggregate demand
is to lower interest rates.
Investment
Lowering interest rates encourages
investment due to the lower cost of
borrowing.
Aggregate Demand
The increased investment caused by
lower interest rates represents an
injection of new spending into the
circular flow.
Aggregate Demand
The increase in investment will kick off
multiplier effects and result in an even
larger increase in aggregate demand.
Price Level (average price)
Multiplier Effects
Direct impact of
increase Investment
spending + $200
billion
P1
Indirect impact via
increased consumption
+ $600 billion
a
b
AD1
5.6
QE
5.8
AD2
Current
price level
AD3
6.4
Real GDP
($ trillions per year)
Monetary Policy and the Multiplier
Aggregate Demand
The Fed’s objective of stimulating the
economy is achieved in three steps:
An increase in the money supply.
 A reduction in interest rates.
 An increase in aggregate demand.

Monetary Stimulus
An increase in the
money supply lowers
the rate of interest
A reduction in the rate
of interest stimulates
investment
More investment increases
aggregate demand
(including multiplier effects)
6
E2
Demand
for money
7
Investment
demand
6
Price Level
7
E1
Interest Rate
Interest Rate
AS
AD1
0
g1 g2
Quantity Of Money
0
AD2
I1 I2
Rate Of Investment
Income (Output)
The Short-Run Determination of the
Interest Rate
Can you walk through how
contractionary monetary
policy plays out?
Fed shrinks the money supply
and…
Federal Reserve Policy and the
Business Cycle