Presentation on theme: "Putting it all together…"— Presentation transcript:
1 Putting it all together… Suppose the economy is currently suffering from a very high rate of inflation caused by aggregate demand that has increased beyond potential GDP.In a correctly labeled graph, show equilibrium in the money market.In a correctly labeled AD/AS graph, show the current short-run equilibrium in the macroeconomy.In response to this high inflation rate, should the Fed engage in expansionary or contractionary monetary policy?In your graph from part a), show the impact of this monetary policy in the money market and on the equilibrium interest rate.In your graph from part b), show the impact of this monetary policy on real GDP and the price level.
2 Initial Graphs LRAS SRAS AD E P1 Y1 YP r1 M1 Agg. Price Level MS Real GDPAgg.PriceLevelEP1Y1YPMSr1M1
3 After Contractionary Policy LRASSRASADReal GDPAgg.PriceLevelEP1Y1YPMS1r1M1MS2AD2r2P2E2M2
4 Monetary Policy and Interest Rates Short-run v. Long-run EffectsKrugman, Modules 31 & 32
5 Expansionary Monetary Policy Chain of Events:The Fed observes that the economy is in a recessionary gap.The Fed increases the money supply.The interest rate falls.Investment and consumption increase.AD shifts to the right.Real GDP increases, unemployment rate decreases, the aggregate price level rises.
6 Contractionary Monetary Policy Chain of Events:The Fed observes that the economy is in a inflationary gap.The Fed decreases the money supply.The interest rate increases.Investment and consumption decrease.AD shifts to the left.Real GDP decreases, unemployment rate increases, the aggregate price level falls.
7 Monetary Policy in Practice How does the Fed know what to aim for?One idea is the Taylor Rule:Federal Funds Rate target is based on inflation rate and output gapFFR = 1 + (1.5 × inflation rate) + (0.5 × output gap)Example: inflation = 3% and output gap = -4%
9 Inflation Targeting Some countries have adopted an inflation target monetary policy is used to keep future inflation within a targeted rangeTransparencyUncertainty is reducedAccountabilitySuccess can be judged
11 Long-Run Impacts of Monetary Policy Ceteris Paribus: changes in the money supply will only result in changes in the aggregate price levelMoney NeutralityPercentage increase in money supply will equal percentage increase in aggregate price levelOutput and Employment will not change in the long runBasis of monetarism
13 And Interest Rates Don’t Change As aggregate price level increases, households increase demand for moneyAs a result, interest rates that fell in the short term will rise as demand catches up to supply