Guide Expansionary Monetary Policy and Aggregate Output Curves

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Recall that the classical economists believe that the economy is always at or near the natural level of real GDP. Furthermore, classical economists argue that the velocity of circulation of money tends to remain constant so that V can also be regarded as fixed. Assuming that both Y and V are fixed, it follows that if the Fed were to engage in expansionary or contractionary monetary policy, leading to an increase or decrease in M , the only effect would be to increase or decrease the price level, P , in direct proportion to the change in M.

Monetary policy

In other words, expansionary monetary policy can only lead to inflation , and contractionary monetary policy can only lead to deflation of the price level. Keynesian view of monetary policy.

Keynesians do not believe in the direct link between the supply of money and the price level that emerges from the classical quantity theory of money. They reject the notion that the economy is always at or near the natural level of real GDP so that Y in the equation of exchange can be regarded as fixed. They also reject the proposition that the velocity of circulation of money is constant and can cite evidence to support their case.

Monetary Policy and its strength in stimulating output in an economy | Project Firefly

Keynesians do believe in an indirect link between the money supply and real GDP. They believe that expansionary monetary policy increases the supply of loanable funds available through the banking system, causing interest rates to fall. Hence, monetary policy can affect real GDP indirectly.

Keynesians, however, remain skeptical about the effectiveness of monetary policy. They point out that expansionary monetary policies that increase the reserves of the banking system need not lead to a multiple expansion of the money supply because banks can simply refuse to lend out their excess reserves.

IS-LM: Fiscal & monetary policy

Furthermore, the lower interest rates that result from an expansionary monetary policy need not induce an increase in aggregate investment and consumption expenditures because firms' and households' demands for investment and consumption goods may not be sensitive to the lower interest rates.

For these reasons, Keynesians tend to place less emphasis on the effectiveness of monetary policy and more emphasis on the effectiveness of fiscal policy, which they regard as having a more direct effect on real GDP.


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When interest rates are cut which is our expansionary monetary policy , aggregate demand AD shifts up due to the rise in investment and consumption. We need to determine the effects of this rise in AD, the price level, and real GDP output in each of our two countries. Recall that in Country A "all wage contracts are indexed to inflation.

Thus due to the wage indexing, wages must rise as well. A rise in wages will shift the aggregate supply curve upwards, moving along the aggregate demand curve. This will cause prices to increase further, but real GDP output to fall. Recall that in Country B "there are no cost-of-living adjustments to wages, but the workforce is completely unionized. The federal funds interest rate fell from In response, the Federal Reserve used contractionary monetary policy to raise the federal funds rates from 6.

In Episode 4, in the early s, when the Federal Reserve was confident that inflation was back under control, it reduced interest rates, with the federal funds interest rate falling from 8.

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As the economy expanded, the unemployment rate declined from 7. Inflation did not rise, and the period of economic growth during the s continued. Then in and , the Fed was concerned that inflation seemed to be creeping up so it raised the federal funds interest rate from 4.

Demand Pull Inflation

By early , inflation was declining again, but a recession occurred in Between and , the unemployment rate rose from 4. In Episodes 7 and 8, the Federal Reserve conducted a loose monetary policy and slashed the federal funds rate from 6. They actually did this because of fear of Japan-style deflation; this persuaded them to lower the Fed funds further than they otherwise would have. The recession ended, but, unemployment rates were slow to decline in the early s. When the Fed had taken interest rates down to near-zero by December , the economy was still deep in recession.

Open market operations could not make the interest rate turn negative. The most powerful and commonly used of the three traditional tools of monetary policy—open market operations—works by expanding or contracting the money supply in a way that influences the interest rate. In late , as the U. With the recession still ongoing, the Fed decided to adopt an innovative and nontraditional policy known as quantitative easing QE.

This is the purchase of long-term government and private mortgage-backed securities by central banks to make credit available so as to stimulate aggregate demand. Quantitative easing differed from traditional monetary policy in several key ways. First, it involved the Fed purchasing long term Treasury bonds , rather than short term Treasury bills. In , however, it was impossible to stimulate the economy any further by lowering short term rates because they were already as low as they could get.

Read the closing Bring it Home feature for more on this. Therefore, Bernanke sought to lower long-term rates utilizing quantitative easing. This leads to a second way QE is different from traditional monetary policy. Instead of purchasing Treasury securities, the Fed also began purchasing private mortgage-backed securities, something it had never done before. The quantitative easing policies adopted by the Federal Reserve and by other central banks around the world are usually thought of as temporary emergency measures.

If these steps are, indeed, to be temporary, then the Federal Reserve will need to stop making these additional loans and sell off the financial securities it has accumulated. The concern is that the process of quantitative easing may prove more difficult to reverse than it was to enact.

An expansionary or loose monetary policy raises the quantity of money and credit above what it otherwise would have been and reduces interest rates, boosting aggregate demand, and thus countering recession.

A contractionary monetary policy, also called a tight monetary policy, reduces the quantity of money and credit below what it otherwise would have been and raises interest rates, seeking to hold down inflation. During the — recession, central banks around the world also used quantitative easing to expand the supply of credit. A well-known economic model called the Phillips Curve discussed in The Keynesian Perspective chapter describes the short run tradeoff typically observed between inflation and unemployment.