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Slides Created By Kevin Brady and Eric Chiang Monetary Policy Interactive Examples 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 CoreEconomics, 2e Begin

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Monetary Policy Aggregate Price Level (P) Aggregate Output (Y) 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. Back Interactive Examples Question: What establishes long-run macroeconomic equilibrium in an economy? Answer

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Aggregate Price Level (P) Aggregate Output (Y) Back Interactive Examples 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. SRAS AD LRAS Next 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? Monetary Policy P0P0 Y0Y0

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Aggregate Price Level (P) Aggregate Output (Y) Back Interactive Examples SRAS 0 AD 0 LRAS 0 Assume the graph to the right represents the U.S economy. Notice that it is in long-run macroeconomic equilibrium. Monetary Policy P0P0 Y0Y0 Question: If there is suddenly a large increase in the demand for U.S. exports, what would happen? Answer

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Aggregate Price Level (P) Aggregate Output (Y) Back Interactive Examples SRAS 0 AD 0 LRAS 0 Next Assume the graph to the right represents the U.S economy. Notice that it is in long-run macroeconomic equilibrium. Monetary Policy P0P0 Y0Y0 Question: If there is suddenly a large increase in the demand for U.S. exports, what would happen? Answer: The increase in net exports will cause the AD 0 curve to shift to AD 1. The new short-run equilibrium is at price level P 1 and output level Y 1. AD 1 Y1Y1 P1P1

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Aggregate Price Level (P) Aggregate Output (Y) Back Interactive Examples SRAS 0 LRAS 0 Notice that while the real output level is higher at Y 1, there is also a higher price level in the economy at P 1. Monetary Policy AD 1 Y1Y1 P1P1 Question: Suppose the Federal Reserve Bank (the Fed) is worried about inflation. What type of policy could they implement to address this concern? Answer

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Aggregate Price Level (P) Aggregate Output (Y) Back Interactive Examples SRAS 0 AD 2 LRAS 0 Next Monetary Policy P0P0 Y0Y0 AD 1 Y1Y1 P1P1 Question: Suppose the Federal Reserve Bank (The Fed) is worried about inflation. What type of policy could they implement to address this concern? 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 P 0 and Y 0.

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Aggregate Price Level (P) Aggregate Output (Y) Back Interactive Examples SRAS 0 AD 0 LRAS 0 Assume the graph to the right represents the U.S economy. Notice that it is in long-run macroeconomic equilibrium. Monetary Policy P0P0 Y0Y0 Question: If firms throughout the economy acquire more market power through deregulation, what effect would this have on our model? Answer

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Aggregate Price Level (P) Aggregate Output (Y) Back Interactive Examples SRAS 0 AD 0 LRAS 0 Next Assume the graph to the right represents the U.S economy. Notice that it is in long-run macroeconomic equilibrium. Monetary Policy P0P0 Y0Y0 Question: If firms throughout the economy acquire more market power through deregulation, what effect would this have on our model? 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 P 1 and output level Y 1. SRAS 1 Y1Y1 P1P1

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Aggregate Price Level (P) Aggregate Output (Y) Back Interactive Examples AD 0 LRAS 0 Notice here we have the worst of both worlds: a higher price level and lower aggregate output! Monetary Policy P0P0 Y0Y0 SRAS 1 Y1Y1 P1P1 Question: What would happen in our model if the Fed implements expansionary monetary policy? Answer

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Aggregate Price Level (P) Aggregate Output (Y) Back Interactive Examples AD 0 LRAS 0 Next Notice here we have the worst of both worlds: a higher price level and lower aggregate output! Monetary Policy P0P0 Y0Y0 SRAS 1 Y1Y1 P1P1 Question: What would happen in our model if the Fed implements expansionary monetary policy? Answer: If the Fed decreased interest rates, the aggregate demand curve would shift to the right. While aggregate output returns to its full employment equilibrium at Y 0, there is now an even higher price level at P 2 ! The gain in output came at the expense of inflation. AD 1 P2P2

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Aggregate Price Level (P) Aggregate Output (Y) Back Interactive Examples AD 0 LRAS 0 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. Monetary Policy P0P0 Y0Y0 SRAS 1 Y1Y1 P1P1 Question: What would happen in our model if the Fed implements contractionary monetary policy? Answer

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Aggregate Price Level (P) Aggregate Output (Y) Back Interactive Examples AD 0 LRAS 0 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. Monetary Policy P0P0 Y0Y0 SRAS 1 Y1Y1 P1P1 Question: What would happen in our model if the Fed implements contractionary monetary policy? 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 Y 2 ! The reduction in inflation came at the expense of aggregate output. Y2Y2 Next

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Aggregate Price Level (P) Aggregate Output (Y) Back Interactive Examples AD 0 LRAS 0 Monetary Policy P0P0 Y0Y0 SRAS 1 Y2Y2 This is why the Fed has a hard job! There is no easy monetary policy solution to an aggregate supply shock. Start Over

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