Short-Run Effects of Money on Real GDP, and the Price Level Ripple Effects of Monetary Policy If the Fed increases the interest rate, three events follow:  Investment (and, to a lesser extent, consumption) demand decreases.  The dollar rises and next export demand decreases. (The higher interest rate leads the rest of the world to want to buy U.S. financial assets, whose rate of return has now increased. This increases the world demand for U.S. dollars and raises its value in world currency markets. As the U.S. dollar becomes more expensive, U.S. goods become relatively more expensive than foreign goods)  A multiplier process unfolds in which aggregate demand decreases and decreases by more than the initial decrease caused by the higher interest rate.

Short-Run Effects of Money on Real GDP, and the Price Level Figure 11.6 summarizes these ripple effects.

Short-Run Effects of Money on Real GDP, and the Price Level The Fed Tightens to Avoid Inflation Figure 11.7 illustrates the attempt to avoid inflation.

Short-Run Effects of Money on Real GDP, and the Price Level A decrease in the money supply in part (a) raises the interest rate.

Short-Run Effects of Money on Real GDP, and the Price Level The rise in the interest rate decreases investment and consumption in part (b).

Short-Run Effects of Money on Real GDP, and the Price Level The decrease in investment and consumption shifts the AD curve leftward with a multiplier effect in part (c).

Short-Run Effects of Money on Real GDP, and the Price Level Real GDP decreases and the price level falls.

Short-Run Effects of Money on Real GDP, and the Price Level The Fed Eases to Avoid Recession Figure 11.8 illustrates the attempt to avoid recession.

Short-Run Effects of Money on Real GDP, and the Price Level An increase in the money supply in part (a) lowers the interest rate.

Short-Run Effects of Money on Real GDP, and the Price Level The fall in the interest rate increases investment and consumption in part (b).

Short-Run Effects of Money on Real GDP, and the Price Level The increase in investment and consumption shifts the AD curve rightward with a multiplier effect in part (c).

Short-Run Effects of Money on Real GDP, and the Price Level Real GDP increases and the price level rises.

Short-Run Effects of Money on Real GDP, and the Price Level The size of the multiplier effect of monetary policy depends on the sensitivity of expenditure plans to the interest rate. Limitations of Monetary Stabilization Policy Monetary policy shares the limitations of fiscal policy, except that there is no law-making time lag or uncertainty. It also has the additional limitation that the effects of monetary policy are long drawn out, indirect, and depend on responsiveness of spending to interest rates. These effects are all variable and hard to predict.