Dynamic AD-AS Model: Monetary Policy - Online Tutor, Practice Problems & Exam Prep

Monetary policy plays a crucial role in managing aggregate demand (AD) and aggregate supply (AS) within the dynamic ADAS model. During a recession, expansionary monetary policy, characterized by lower interest rates, stimulates spending and investment, shifting AD rightward to reach long-run equilibrium. Conversely, in inflationary periods, contractionary monetary policy raises interest rates, reducing AD to stabilize prices. Understanding these mechanisms is essential for grasping how central banks influence economic stability through adjustments in the money supply and interest rates.

Dynamic AD-AS Model: Expansionary Monetary Policy

So now, let's see how Monetary Policy fits into the dynamic ADAS model. I want to point out again, remember, the dynamic ADAS model is not for everybody. Some professors like to use it, a lot of them just skip over it. It's optional in this course and most professors don't do it. But if yours is really going for it, let's go ahead and do the dynamic ADAS model here. Alright. So now, let's think about monetary policy with this model. First, let's remember our key assumptions with this model, that everything is increasing generally year over year. What we're going to have is the long-run aggregate supply shifting to the right, the short-run aggregate supply shifting to the right, and the aggregate demand shifting to the right as well. However, if they don't all grow in unison, well, we can end up in a recessionary state or an inflationary state. Let's start here with a recession. Now, one thing I want to note, if you've already looked at fiscal policy aggregate demand. With the fiscal policy, the government is changing their spending. With monetary policy, the Fed is affecting the money supply to affect aggregate demand. Okay? So let's go ahead and look here first at expansionary monetary policy, which happens during a recession. So in a recession, we're below our potential GDP and we want to boost spending to reach our potential GDP. Okay? An expansionary monetary policy, what the Fed does is lower interest rates, right? They're going to lower interest rates to stimulate the economy. By lowering interest rates, people are going to want to spend more money, right? Firms are going to take out loans and they're going to build new factories, new investments, and homeowners as well can take out loans at lower interest rates as well. So the lower interest rates stimulate the economy and increase our aggregate demand. Okay? So let's look at the graph here. And if you remember, if you've done the fiscal policy, go back and look at that one and you'll see how similar the discussions here and there are. Alright. So what we have is our original situation where we were in an equilibrium here at point A. Okay? Okay? So that's our original equilibrium. Let's label our graph real quick. We've got our price level and our real GDP, and we've got our long-run aggregate supply 1, short-run aggregate supply 1, and aggregate demand 1. Okay? And what we're going to do is we're going to shift these curves like we do in the dynamic model. Everything's going to shift to the right. However, in this case, aggregate demand does not shift enough to meet our new long-run equilibrium. So what we're going to do is we're going to have the monetary policy, the expansionary policy boost aggregate demand to reach the equilibrium. So let's see what I mean here. First, let's shift all our curves. The long-run aggregate supply is shifting to the right. The short-run aggregate supply is also shifting to the right. And aggregate demand, remember, it didn't grow enough. This is the whole reason why we have the expansionary policy. So what we're going to do is we're only going to shift aggregate demand a little bit here. We're going to shift it a little bit here to get to this aggregate demand 2. Right? And notice that we haven't reached our potential GDP here. Our short-run equilibrium is just shy of our long-run equilibrium where the whole star, would meet here. And that's because aggregate demand didn't grow enough. Okay? So with the expansionary Monetary Policy, the money supply, the Fed lowers the interest rates, right? They lower interest rates by increasing the money supply, which leads to lower interest rates, which leads to increases in aggregate demand just like we were talking about. And these increases in aggregate demand will get us to our long-run equilibrium at AD3 with monetary policy, right? The monetary policy pushes the aggregate demand out to our long-run equilibrium. And we're now at this point C where the three curves are touching and now we're back to our long-run equilibrium there in the new year. Okay? So that's the whole point of expansionary policy is to keep us at long-run equilibrium and fight a recession when aggregate demand is not enough. Alright? So there we go. We're back to our long-run equilibrium. Let's pause here and let's talk about inflationary periods in the next video.

Dynamic AD-AS Model: Contractionary Monetary Policy

So when we're in a situation where we have rising inflation, that means our economy is beyond its potential GDP. Aggregate demand has increased too much and we've gone beyond our potential GDP and we need to pull back on aggregate demand just a little bit. So, to have contractionary fiscal policy means we are less incentivized to spend money, right? Firms are not going to spend as much money at the higher interest rates to borrow money, to get a loan. The same with houses as well, right? So, at these higher interest rates, it's going to reduce our inflation by reducing our aggregate demand. Okay? So contractionary is going to lead us to have less GDP.

Let's go ahead and look at this situation on the graph. The first thing that's going to happen here is we're going to have our original equilibrium at point A with long run aggregate supply 1 (LRAS 1), short run aggregate supply 1 (SRAS 1), and aggregate demand 1 (AD 1). Okay? And remember, this is our price level and real GDP. Now in this situation, everything is going to grow, but aggregate demand is going to grow a lot. Okay? Let's start with our long run aggregate supply shifting to the right, and now our short run aggregate supply is also shifting to the right, but our aggregate demand is going to shift way to the right.

There was way too much increase in aggregate demand, and it leads us to this situation where we have, higher prices in the short run equilibrium here, right? The short run equilibrium at point B is beyond our potential output, right? Our potential GDP here at LRAS 2 is less than our GDP here in our short run equilibrium, right? So this is why we lead to higher prices, right? We've got our original price here and the higher price, in the short run equilibrium.

I want to take those out so that it doesn't get too messy here. Alright? So with the contractionary monetary policy, it's going to pull back on the aggregate demand a little bit. The higher interest rates are going to reduce investment spending as well as consumption. So what we're going to do is we're going to have a third aggregate demand curve, and we're going to shift to the left here to get to our equilibrium at AD 3. And this is with the monetary policy. Okay. The monetary policy pulls back the aggregate demand a little bit and now we're in our long run equilibrium at point C. Right? At point C, we get to our long run equilibrium and everything's back to normal there. Right? Our price level has stabilized, and we have those dynamic increases in the model. Cool?

Remember, this is very similar to what we learned with fiscal policy. So if you get one, you've got the other one as well. Alright. Let's pause here and let's move on to the next video.

Here’s what students ask on this topic:

What is the dynamic AD-AS model in macroeconomics?

The dynamic AD-AS model in macroeconomics is an extension of the traditional Aggregate Demand (AD) and Aggregate Supply (AS) model. It incorporates the idea that key economic variables such as long-run aggregate supply (LRAS), short-run aggregate supply (SRAS), and aggregate demand (AD) generally increase over time. This model helps to analyze how the economy evolves over multiple periods, considering factors like technological progress, population growth, and changes in capital stock. It is particularly useful for understanding how monetary and fiscal policies impact the economy in the long run, addressing issues like inflation and recession.

How does expansionary monetary policy affect the dynamic AD-AS model during a recession?

During a recession, expansionary monetary policy aims to boost economic activity by lowering interest rates. In the dynamic AD-AS model, this policy shifts the aggregate demand (AD) curve to the right. Lower interest rates make borrowing cheaper, encouraging both consumer spending and business investment. As a result, aggregate demand increases, moving the economy closer to its potential GDP. This helps to reduce the recessionary gap, bringing the economy back to long-run equilibrium where the long-run aggregate supply (LRAS), short-run aggregate supply (SRAS), and aggregate demand (AD) curves intersect.

What role does contractionary monetary policy play in the dynamic AD-AS model during inflationary periods?

In inflationary periods, contractionary monetary policy aims to reduce excessive economic activity by raising interest rates. In the dynamic AD-AS model, this policy shifts the aggregate demand (AD) curve to the left. Higher interest rates make borrowing more expensive, discouraging both consumer spending and business investment. As a result, aggregate demand decreases, helping to stabilize prices and reduce inflation. This adjustment moves the economy back to its long-run equilibrium, where the long-run aggregate supply (LRAS), short-run aggregate supply (SRAS), and aggregate demand (AD) curves intersect, ensuring economic stability.

How do changes in the money supply influence aggregate demand in the dynamic AD-AS model?

Changes in the money supply directly influence aggregate demand (AD) in the dynamic AD-AS model. When the central bank increases the money supply, it typically lowers interest rates, making borrowing cheaper. This encourages consumer spending and business investment, shifting the AD curve to the right. Conversely, when the central bank decreases the money supply, it raises interest rates, making borrowing more expensive. This discourages spending and investment, shifting the AD curve to the left. These shifts help manage economic stability by addressing issues like recession and inflation.

What are the key assumptions of the dynamic AD-AS model?

The dynamic AD-AS model operates under several key assumptions: (1) Economic variables such as long-run aggregate supply (LRAS), short-run aggregate supply (SRAS), and aggregate demand (AD) generally increase over time. (2) Technological progress, population growth, and capital stock changes drive these increases. (3) The model assumes that if these variables do not grow in unison, the economy can experience either a recessionary gap or an inflationary gap. These assumptions help in understanding how monetary and fiscal policies impact the economy over multiple periods, ensuring long-term economic stability.