Assume the US economy is operating at an aggregate output level above potential output.
Draw a graph showing AD, SRAS, LRAS, equilibrium output & aggregate price level.
Now assume the Fed uses contractionary monetary policy.
Identify the open-market operation the Fed would use and draw a money market graph to show the effect of monetary policy on the nominal interest rate.
Show how the Fed's actions will affect equilibrium in the aggregate demand and supply graph you drew previously and the new aggregate price level.
Draw a graph of the foreign exchange market for the US dollar relative to the Euro
How will the Fed's contractionary monetary policy affect the real interest rate in the US?
The Inflationary Gap
Aggregate output level above potential output: inflationary gap
x-axis: Y = rGDP (real GDP)
y-axis: Aggregate Price Level
Consumer Expenditures + Business Investment + Government Expenditures + Net Exports
Y = C + I +G + NX
- Up-ward sloping curve
Equilibrium output & aggregate price level
- The intersection of AD and SRAS
To the left of the equilibrium
Aggregate output level is above the potential output
Potential output (Yp)
- The intersection of LRAS and x-axis
|Expansionary Monetary Policy||Contractionary Money Policy|
x-axis: Quantity of Money
y-axis: Nominal Interest Rate (r)
- Downward sloping curve
Straight Vertical Line, since the Fed control the money supply
Expansionary: MS shifts to the right, lowing the nominal interest rate
Contractionary: MS shifts to the left, raising the nominal interest rate
Higher interest rate = Decreased investment
When interest rates go up, both consumption and investment decrease.
Y↓ = C↓ + I↓ + G +NX
Aggregate Price ↓ as a result of contractionary monetary policy
x-axis: Quantity of Dollars
y-axis: Euros per Dollar
No effect in the long-run.
Since money is neutral, monetary has a short-run but not a long-run impact
Price level↓ Demand for US dollar↑
Dollar has appreciated, because demand for US dollars has increased
Major Factors that Shift Curves in Each Model