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**Chapter 23 Monetary Policy**

Interactive Examples Monetary Policy Begin To navigate, please click the appropriate green buttons. (Do not use the arrows on your keyboard) Material from this presentation can be found in: Chapter 23 Slides Created By Kevin Brady and Eric Chiang CoreEconomics, 2e

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Interactive Examples Monetary Policy Aggregate Price Level (P) We introduced the AD/AS model earlier. Recall that the model shows the relationship between the aggregate output of goods and services in the economy and the price level. Question: What establishes long-run macroeconomic equilibrium in an economy? Aggregate Output (Y) Back Answer

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Interactive Examples Monetary Policy Next Aggregate Price Level (P) We introduced the AD/AS model earlier. Recall that the model shows the relationship between the aggregate output of goods and services in the economy and the price level. LRAS SRAS Question: What establishes long-run macroeconomic equilibrium in an economy? P0 Answer: Long-run macroeconomic equilibrium occurs at the intersection of the short-run aggregate supply curve (SRAS), the aggregate demand curve (AD), and the long-run aggregate supply (LRAS) curve. AD Aggregate Output (Y) Y0 Back 3

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Interactive Examples Monetary Policy Aggregate Price Level (P) Assume the graph to the right represents the U.S economy. Notice that it is in long-run macroeconomic equilibrium. LRAS0 SRAS0 Question: If there is suddenly a large increase in the demand for U.S. exports, what would happen? P0 AD0 Aggregate Output (Y) Y0 Back Answer 4

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Interactive Examples Monetary Policy Next Aggregate Price Level (P) Assume the graph to the right represents the U.S economy. Notice that it is in long-run macroeconomic equilibrium. LRAS0 SRAS0 P1 Question: If there is suddenly a large increase in the demand for U.S. exports, what would happen? P0 Answer: The increase in net exports will cause the AD0 curve to shift to AD1. The new short-run equilibrium is at price level P1 and output level Y1. AD1 AD0 Aggregate Output (Y) Y0 Y1 Back 5

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Interactive Examples Monetary Policy Aggregate Price Level (P) Notice that while the real output level is higher at Y1, there is also a higher price level in the economy at P1. LRAS0 SRAS0 P1 Question: Suppose the Federal Reserve Bank (the Fed) is worried about inflation. What type of policy could they implement to address this concern? AD1 Aggregate Output (Y) Y1 Back Answer 6

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Interactive Examples Monetary Policy Next Aggregate Price Level (P) Question: Suppose the Federal Reserve Bank (The Fed) is worried about inflation. What type of policy could they implement to address this concern? LRAS0 SRAS0 P1 Answer: The Fed could implement contractionary monetary policies to reduce aggregate demand. They can achieve this by raising interest rates, which would reduce investment, or by selling government bonds, which would reduce the money available for consumption. This would return the economy to long-run equilibrium at P0 and Y0. P0 AD1 AD2 Aggregate Output (Y) Y0 Y1 Back 7

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Interactive Examples Monetary Policy Aggregate Price Level (P) Assume the graph to the right represents the U.S economy. Notice that it is in long-run macroeconomic equilibrium. LRAS0 SRAS0 Question: If firms throughout the economy acquire more market power through deregulation, what effect would this have on our model? P0 AD0 Aggregate Output (Y) Y0 Back Answer 8

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Interactive Examples Monetary Policy Next Aggregate Price Level (P) Assume the graph to the right represents the U.S economy. Notice that it is in long-run macroeconomic equilibrium. LRAS0 SRAS1 SRAS0 Question: If firms throughout the economy acquire more market power through deregulation, what effect would this have on our model? P1 P0 Answer: The increase in market power will allow firms to reduce supply and make larger profits. The SRAS curve will shift to the left, resulting in a new short-run equilibrium at price level P1 and output level Y1. AD0 Aggregate Output (Y) Y1 Y0 Back 9

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Interactive Examples Monetary Policy Aggregate Price Level (P) Notice here we have the worst of both worlds: a higher price level and lower aggregate output! LRAS0 SRAS1 Question: What would happen in our model if the Fed implements expansionary monetary policy? P1 P0 AD0 Aggregate Output (Y) Y1 Y0 Back Answer 10

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Interactive Examples Monetary Policy Next Aggregate Price Level (P) Notice here we have the worst of both worlds: a higher price level and lower aggregate output! LRAS0 SRAS1 Question: What would happen in our model if the Fed implements expansionary monetary policy? P2 P1 P0 Answer: If the Fed decreased interest rates, the aggregate demand curve would shift to the right. AD1 While aggregate output returns to its full employment equilibrium at Y0, there is now an even higher price level at P2! The gain in output came at the expense of inflation. AD0 Aggregate Output (Y) Y1 Y0 Back 11

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Interactive Examples Monetary Policy Aggregate Price Level (P) Let’s take a step back and see what happens if the Fed uses a different strategy to cope with the higher price level and lower output level resulting from a negative supply shock. LRAS0 SRAS1 Question: What would happen in our model if the Fed implements contractionary monetary policy? P1 P0 AD0 Aggregate Output (Y) Y1 Y0 Back Answer 12

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Interactive Examples Monetary Policy Next Aggregate Price Level (P) Let’s take a step back and see what happens if the Fed uses a different strategy to cope with the higher price level and lower output level resulting from a negative supply shock. LRAS0 SRAS1 Question: What would happen in our model if the Fed implements contractionary monetary policy? P1 P0 Answer: If the Fed increased interest rates, the aggregate demand curve would shift to the left. While the price level returns to its original equilibrium, there is now an even lower output level at Y2! The reduction in inflation came at the expense of aggregate output. AD0 Aggregate Output (Y) Y2 Y1 Y0 Back 13

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Interactive Examples Monetary Policy Aggregate Price Level (P) LRAS0 SRAS1 This is why the Fed has a hard job! There is no easy monetary policy solution to an aggregate supply shock. P0 AD0 Aggregate Output (Y) Y2 Y0 Back Start Over 14

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