Expansionary and Contractionary Monetary Policy - Online Tutor, Practice Problems & Exam Prep

The relationship between the money market and the aggregate demand curve is crucial for understanding monetary policy. The Federal Reserve employs expansionary monetary policy during recessions by lowering interest rates to stimulate investment and increase aggregate demand. Conversely, in inflationary periods, contractionary monetary policy raises interest rates to reduce aggregate demand and stabilize the economy. These actions shift the aggregate demand curve, impacting GDP and the price level, ultimately guiding the economy towards its long-run equilibrium.

Expansionary Monetary Policy

So, let's continue the discussion on the relationship between the money market and the aggregate demand curve by including the entire aggregate demand aggregate supply model. This is the AD-AS model that we've learned previously. We're going to see how the money market affects this model. So, remember, the Fed has two main goals when it comes to monetary policy: managing the employment level in the economy and ensuring price stability, right? They want high employment and they don't want prices to go out of control through high inflation. So, when the economy is in recession, real GDP is below its potential output. We're in a recession; the spending is low, and there's not as much GDP happening as we would want.

During this recession, we see cyclical unemployment. So, there's a lot of unemployment and there's low investment going on which is affecting aggregate demand, right? This investment causes aggregate demand to be down because there isn't much investment happening during the recession. So, the Fed is going to employ what's called expansionary monetary policy. They want the economy to expand. Right? "Expansionary" means they want more GDP. They want GDP to increase. So, how do they get GDP to increase? They want to entice investment. So, how can they entice investment by managing the interest rate? They can lower the interest rate, right? If they can get a lower interest rate in the economy, well, it's going to entice businesses to spend money, right? There's low interest; they can make investments in long-term purchases because they can take out loans at a lower cost.

So, let's look at how an expansionary monetary policy looks like in the money market and our AD-AS model. We're in a recession. Right? Let's look at our AD-AS model and let's label it real quick. In our AD-AS model, we have our price level and our GDP. Right? The real GDP on our x-axis. Let's get out of the way. What curves are on our graph here? We've got our long-run aggregate supply, our short-run aggregate supply, and our aggregate demand curve. Right? There's no short-run or long-run with the aggregate demand. We just have one curve there. Notice what's happening here. Our short-run equilibrium where the aggregate demand and the short-run aggregate supply are lower than our long-run equilibrium GDP, right? In the short run, I'm going to say short-run equilibrium is going to have a lower GDP, right? Lower GDP because we're in a recession, right? The short-run equilibrium has this lower amount of GDP and this is the price level currently. So, we'll say P1 here in this case.

Now, what does the Fed want to do? The Fed wants to employ expansionary monetary policy. They want to get us back to this higher level of GDP, our long-run equilibrium level of GDP. They want to increase the amount of GDP and, like we said, they're going to lower the interest rate to stimulate the economy. Okay? So, how are they going to do that? First, look into the money market. Remember, in the money market, we have our interest rate on the Y-axis and we've got the quantity of money here on the x-axis, right? The interest rate, being the price of money, and they want to bring the interest rate down. Right now, the money supply is here at MS1. The money demand is here, and we've got this equilibrium interest rate right here, R1.

So, they want to bring the interest rate down, right? They want the interest rate lower to stimulate the economy and increase investment. So, they want to bring it down here to R2. What do they have to do in the money supply to get to this new equilibrium interest rate? Do they need to increase or decrease the money supply? They need to increase the money supply, right? By having a higher money supply, then we would have a new equilibrium down where we want it at R2. This new money supply by expanding the money supply will have the new equilibrium at this lower rate, which is R2. Right? So, that would be their target is to increase the money supply by that much to lower the interest rate by that much. So, what are they going to do in this case? Do they buy or sell Treasury securities? Remember, this is always the case: the Fed is either buying or selling Treasury securities from the public to affect the money supply. So, the Fed is giving something to the public and the public is giving something to the Fed here. The Fed is either giving up money or getting money. They want to increase the money supply, right? So, they want to increase the money in the hands of the public. So, they're going to give money to the public in this case, and they're going to get securities, right? They're going to purchase the securities. So, in this case, they're purchasing securities to increase the money supply, which leads to a lower interest rate.

Okay? So, this is how all of these moving pieces work, right? We're starting with the purchase of securities, which leads to a higher money supply, which leads to a lower interest rate, and this lower interest rate, how is it going to affect our AD-AS model? This is the final piece of the puzzle. This is why the Fed did all of this: because they want to affect the AD-AS model and get us back to our long-run GDP equilibrium. So, at this lower interest rate, we already said that it's going to affect investment, right? There's an increase in investment, but there's also increases in consumption and net exports, as well. All of those are affected by the lower_interest_rate. The lower interest rate leads to higher consumption, higher investment, higher net exports; all of these moving parts. So the goal of the Fed is to shift the aggregate demand curve. They want the aggregate demand curve to increase. So, they're enticing people to spend more money, not just the citizens, but the firms as well, and foreigners as well. So in this case, what's going to happen is the aggregate demand curve is going to shift to the right. We're going to have this shift to the right, to this new equilibrium over here; we'll get it to cross in the middle there. This is our aggregate demand 2. So, the final piece of the puzzle there, leading to our new long-run equilibrium right here. So, our long-run equilibrium right here; we're now back to our full potential of GDP in our long-run equilibrium. But what's happened to the price level? In this long-run equilibrium, we find that we have a higher price level, right? A higher price level in this long-run equilibrium. So, there are a lot of moving parts there, right? We saw a lot of things happening, but it all comes down to what open market operation did the Fed do, how does that affect our money market, and the relationship between the level of the interest rate and aggregate demand as well. Alright? So now, let's see the opposite: where the Fed wants to employ contractionary monetary policy. Let's see it in...

Contractionary Monetary Policy

So it may sound weird, but the Fed may also want to decrease GDP. And that would be in a situation where we have a lot of inflation. We see a lot of inflation in the economy and we have what's called the economy is hot in this case. We're basically past our long-run GDP level and we're producing at a place past our potential, our potential GDP. How do we do that? Well, it could be a situation here where we have rising inflation pushing us to a point where we're beyond our long-run equilibrium. So let's go ahead and see how this happens. In periods of rising inflation where the price levels are increasing a lot, there's going to be over employment. So basically, people are going to be working longer hours than they generally would. People who wouldn't have jobs are now in the labor force because the economy is so hot that they want to get in on a piece of the action. So we actually have overemployment in the economy and we have increasing price levels. So the economy is basically what we say really hot and we're experiencing a lot of inflation. So the Fed is going to go through what's called contractionary monetary policy to get us back to a maintain a level of GDP that's sustainable. Right? A level that we can sustain in the long run. So the contractionary monetary policy is where the Fed increases interest rates. So this is the opposite of what we just talked about with expansionary. So they're increasing the interest rates to reduce the level of inflation. So when expansionary was more GDP, contractionary is to get us to less GDP. Alright? So let's go ahead and label our graphs again. In this case, we've got our ADAS model with our price level and our GDP, our real GDP here on the graph. Let me get out of the way again. And what's going on in this graph is we've got our long-run aggregate supply below our short-run equilibrium. So over here, we've got our short-run aggregate supply and our aggregate demand and look at our short-run equilibrium right here. Right here, where the short-run aggregate supply and the aggregate demand curve cross, we're at this level of GDP. Short-run Equilibrium GDP that's beyond our sustainable long-run aggregate this is our potential here and we're past it. We're overemployed. We have a lot of inflation leading to this higher level of GDP in the economy. Okay? So the Fed wants to step in and get us back to our long-run equilibrium here. They want to affect, the money market, the money supply to increase the interest rates to reduce our aggregate demand. So let's go ahead and see how all these puzzle pieces move together. So if this was the price one where we started at our short-run equilibrium, let's see what happens to that price level through their contractionary policy. So let's go to the money market where the Fed is going to have an impact. So we see interest rates right here on the y-axis and we have the quantity of money on the x-axis. Our money supply going straight up and down fixed by the Fed and our money demand right there with the downward demand we're used to. And we've got this original quantity, quantity 1 of money. Now the Fed wants to increase interest rates. So here's our equilibrium interest rate, R one, where we started. And they want to get us to a higher interest rate, they want to bring interest rates up to slow down the economy. They're trying to increase the interest rates to slow down the economy, make it less enticing for investors, for consumers, for net exports. Right? All of this we want to be decreasing. So if they want this higher level of interest rate, what are they going to do in this case? Are they going to increase or decrease money supply over here to the left or a money supply over here to the right to get a higher equilibrium? They want it to move to the left. They want to contract the money supply. Right? They wanted less money in the money supply leads to a higher interest rate. So money supply 2 over here, money supply 1, and we get this higher equilibrium interest rate at R2 right there. R2 with a higher equilibrium interest rate. So what does the Fed have to do? What kind of open market operation? So let's think about it. We've got the Fed over here. The Fed public give to the Fed something. So in this case, the Fed wants to decrease the money supply. So do they want to give money to the public or take money from and the Fed is selling and the Fed is selling securities to the public for that. Right? So the public is going to receive securities. So in this case, the Fed sells Fed sells securities, right? They're selling securities to decrease the money supply, which increases the interest rate. So just like we saw the interest rate affecting the aggregate demand before, it's still going to affect it here. Now, at the higher interest rate, what do we see happening? Investment is going to decrease. Right? The firms are going to invest less because loans cost more money. Consumers are going to spend less at the higher interest rate. They might be enticed to save more money as well as just not take out loans on cars and things like that. And net exports, we also saw decrease based on how this affects foreigners as well. So since all of these components of aggregate demand are decreasing, aggregate demand is going to decrease as well. So this is exactly what they want. They want the Fed wants aggregate demand decrease to get us to a more stable level of GDP and lower price level in the economy. So if this was AD 1 on the graph already and we're seeing aggregate demand decrease, we're going to have a shift to the left. So this shift to the left is going to draw a new line, a new aggregate demand over here. This is where they want the aggregate demand to land. Over there at our long-run equilibrium. So notice, we're back to a long-run equilibrium here where our short-run aggregate supply, our aggregate demand, and our long-run aggregate supply are all together once again. Okay? So where are we in this happy little place that we found? We found that the Fed has succeeded in lowering the price level. Right? The new equilibrium that we found in the short-run and long-run here at the green star shape has a lower price level. And that was from this whole process of selling securities to decrease the money supply which led to a higher equilibrium interest rate, and the higher equilibrium interest rate shifted our aggregate demand curve leading to a lower equilibrium price level. Wow. That's a big domino effect. Right? But that's all that's going on is basically thinking of how we're affecting the money supply and what that does to our aggregate demand curve. Okay? And we're just looking for those equilibrium like we're used to in general. So this can be a little tricky and it's always worth studying this in a little more detail because this is a big topic in this class. Alright? So when you're ready, let's go ahead and move on to the next topic.

Here’s what students ask on this topic:

What is expansionary monetary policy and how does it affect the economy?

Expansionary monetary policy is a strategy used by the Federal Reserve to stimulate economic growth during a recession. The Fed lowers interest rates to make borrowing cheaper, encouraging businesses and consumers to invest and spend more. This increase in investment and consumption shifts the aggregate demand curve to the right, leading to higher GDP and potentially higher price levels. The goal is to move the economy towards its long-run equilibrium, reducing cyclical unemployment and increasing overall economic activity.

How does contractionary monetary policy help control inflation?

Contractionary monetary policy is employed by the Federal Reserve to control inflation when the economy is overheating. The Fed raises interest rates, making borrowing more expensive. This discourages investment and consumption, leading to a decrease in aggregate demand. The aggregate demand curve shifts to the left, reducing GDP and lowering price levels. By doing so, the Fed aims to bring the economy back to its long-run equilibrium, stabilizing prices and preventing the negative effects of high inflation.

What are the main tools used by the Federal Reserve in monetary policy?

The Federal Reserve uses several tools to implement monetary policy, including open market operations, the discount rate, and reserve requirements. Open market operations involve buying or selling government securities to influence the money supply. The discount rate is the interest rate charged to commercial banks for borrowing funds from the Fed. Reserve requirements dictate the minimum amount of reserves banks must hold against deposits. These tools help the Fed manage interest rates and control the money supply to achieve its economic goals.

How does the Federal Reserve's open market operations influence interest rates?

Open market operations are a primary tool used by the Federal Reserve to influence interest rates. When the Fed buys government securities, it increases the money supply, leading to lower interest rates. Conversely, when the Fed sells government securities, it decreases the money supply, causing interest rates to rise. By adjusting the money supply through these operations, the Fed can influence borrowing costs, investment, and overall economic activity, helping to achieve its monetary policy objectives.

What is the relationship between the money market and the aggregate demand curve?

The money market and the aggregate demand curve are closely related. Changes in the money market, such as adjustments in the money supply and interest rates, directly impact aggregate demand. For example, an increase in the money supply lowers interest rates, making borrowing cheaper and encouraging investment and consumption. This shifts the aggregate demand curve to the right, increasing GDP and price levels. Conversely, a decrease in the money supply raises interest rates, reducing investment and consumption, and shifting the aggregate demand curve to the left, lowering GDP and price levels.