The Scenario

  • 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

  • Axes

    • x-axis: Y = rGDP (real GDP)

    • y-axis: Aggregate Price Level

  • Aggregate Demand

    • Consumer Expenditures + Business Investment + Government Expenditures + Net Exports

    • Y = C + I +G + NX

  • SRAS

    • Up-ward sloping curve
  • Equilibrium output & aggregate price level

    • The intersection of AD and SRAS
  • LRAS

    • To the left of the equilibrium

    • Aggregate output level is above the potential output

  • Potential output (Yp)

    • The intersection of LRAS and x-axis


Money Market

Expansionary Monetary Policy Contractionary Money Policy
  • Lower Discount Rate

  • Raise Discount Rate

  • Lower RRR

  • Raise RRR

  • Buy Government Securities After Lowering Target Fed Funds Rate
    (Open Market Operation)

  • Sell Government Securities After Raising of Target Fed Funds Rate
    (Open Market Operation)


  • Axes

    • x-axis: Quantity of Money

    • y-axis: Nominal Interest Rate (r)

  • Money Demand

    • Downward sloping curve
  • Money Supply

    • 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

    Interest rate, r MS2 MSI MD Quantity of money

New Equilibrium

  • Higher interest rate = Decreased investment

  • When interest rates go up, both consumption and investment decrease.

  • Y↓ = C↓ + I↓ + G +NX

  • Aggregate Demand↓

  • Aggregate Price as a result of contractionary monetary policy

    Aggregate price level IRAS ADI AD2 SRAS Real GDP

Exchange Market

  • Axes

    • 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

    Exchange rate (Canadian dollars per U.S. dollar) XR2 XRI Supply of
U.S. dollars Quantity of U.S. dollars

Major Factors that Shift Curves in Each Model

Aggregate Demand and Aggregate Supply Short-run Aggregate Supply Curve
Long-run Aggregate Supply Curve Aggregate Demand Curve Expectations
Wealth Size of existing capital stock Fiscal and monetary policy Net
Exports Interest rates Investment spending Demand Curve Income Commodity
prices Nominal wages Productivity Business taxes Supply and Demand
Productivity Physical capital Human capital Technology Quantity of
resources Prices of substitutes and complements Tastes Consumer
expectations Number of consumers Demand Curve Investment opportunities
Government borrowing Supply Curve Input prices Prices of substitutes and
complements in production Technology Producer expectations Number of
producers Loanable Funds Market Supply Curve Private saving behavior
Capital inflows

Demand Curve Aggregate price level Real GDP Technology (related to
money market) Institutions (related to money market) Demand Foreigners'
purchases of domestic Goods Services Assets Money Market Supply Curve
Set by the Federal Reserve Foreign Exchange Market Supply Domestic
residents' purchases of foreign Goods Services Assets

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