Dynamic AD-AS Model: Monetary Policy - Video Tutorials & Practice Problems
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IMPORTANT:Many professors ignore the dynamic AD-AS model in an introductory economics class. Double check with your class notes before you spend time on these videos!
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Dynamic AD-AS Model: Expansionary Monetary Policy
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So now let's see how monetary policy fits in to the dynamic A. D. A. S. Model. So I want to point out again remember dynamic A. D. A. S. 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 some most professors don't do it but if yours is really going for it, let's go ahead and do the dynamic A. D. A. S. Model here. Alright, so now let's think about monetary policy with this model first. Let's let's remember our our key assumptions with this model um that everything is increasing generally year over year. So we're gonna have is long run aggregate supply shifting to the right short run aggregate supply shifting to the right and aggregate demand shifting to the right as well. However, if they don't all grow in unison, what we can end up in a recessionary state or an inflationary state, let's start here with recession. Now one thing I want to know if you've already looked at fiscal policy in the dynamic model, well you're gonna see it's very similar to monetary policy in this model. It's just what we're doing to affect 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 um 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 so an expansionary monetary policy, what the Fed does is lower interest rates, right? They're gonna lower interest rates to stimulate the economy by having lower interest rates. People are gonna want to spend more money, right? Firms are going to take out loans and they're gonna build new 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 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, so that's our original equilibrium. Let's label our graph real quick. We've got our price level and are real GDP we've got our long run aggregate supply one short run aggregate supply one and aggregate demand one. Okay. And what we're gonna do is we're gonna shift these curves like we do in the dynamic model. Everything's gonna 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 gonna do is we're gonna 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. Long run aggregate supply is shifting to the right short run aggregate supply is also shifting to the right, okay. And aggregate demand. Remember it didn't grow enough. This is the whole reason why we have the expansionary policy. So what we're gonna do is we're only gonna shift aggregate demand a little bit here, we're gonna only shift it a little bit, whoops, shifted a little bit here to get to this aggregate demand to write and notice that we haven't reached our potential GDP here are 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 they lower the interest rates by increasing the money supply, leads the lower interest rates leads to increases in aggregate demand. Just like we were talking about and these increases to aggregate demand Will get us to our long run equilibrium at AD three With monetary policy. Right. The monetary policy pushes the aggregate demand out to our long run equilibrium and we're now at this point, see where the three 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.
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 to contract the economy, the Fed is going to increase interest rates and this is the opposite of expansionary policy, right? By increasing the interest rates, well people are less incentivized to spend money right? There, firms are not gonna spend as much money at the higher interest rates uh to borrow money to get alone. Same with houses as well. Right? So at these higher interest rates it's going to reduce our inflation by reducing our um reducing our aggregate demand. Okay so contractionary is gonna lead us to have less G. D. P. So let's go ahead and look at this situation on the graph. The first thing that's gonna happen here is we're gonna have our original our original equilibrium at point A with the long run aggregate supply one short run aggregate supply one and aggregate demand one. Okay and remember this is our price level and real GDP now in this situation everything is gonna grow. But aggregate demand is gonna grow a lot. Okay so 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 gonna shift way to the right, okay, there's way too much increase in aggregate demand. And it leads us to this situation where we have uh higher prices in the short run equilibrium here, right? This short run equilibrium at point B Is beyond our potential output. Right? Our potential GDP here at RLRAS two 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 gonna 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 gonna do is we're gonna have a third aggregate demand curve and we're gonna shift to the left here to get to our equilibrium at 83 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 uh we've we have those dynamic increases in the model. Cool. So remember this is very similar to what we learn with fiscal policy. So if you get one you got the other one as well. Alright, let's pause here and let's move on to the next video.