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.

Initial Graphs LRAS SRAS AD E P1 Y1 YP r1 M1 Agg. Price Level MS Real GDP Agg. Price Level E P1 Y1 YP MS r1 M1

After Contractionary Policy LRAS SRAS AD Real GDP Agg. Price Level E P1 Y1 YP MS1 r1 M1 MS2 AD2 r2 P2 E2 M2

Monetary Policy and Interest Rates Short-run v. Long-run Effects Krugman, Modules 31 & 32

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.

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.

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 gap FFR = 1 + (1.5 × inflation rate) + (0.5 × output gap) Example: inflation = 3% and output gap = -4%

Figure 31.4 (c) Tracking Monetary Policy Using the Output Gap, Inflation, and the Taylor Rule Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Inflation Targeting Some countries have adopted an inflation target monetary policy is used to keep future inflation within a targeted range Transparency Uncertainty is reduced Accountability Success can be judged

Unnumbered Figure 31.2 What the Fed Wants, the Fed Gets Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Long-Run Impacts of Monetary Policy Ceteris Paribus: changes in the money supply will only result in changes in the aggregate price level Money Neutrality Percentage increase in money supply will equal percentage increase in aggregate price level Output and Employment will not change in the long run Basis of monetarism

Figure 32.1 The Short-Run and Long-Run Effects of an Increase in the Money Supply Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

And Interest Rates Don’t Change As aggregate price level increases, households increase demand for money As a result, interest rates that fell in the short term will rise as demand catches up to supply

Figure 32.2 The Long-Run Determination of the Interest Rate Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Unnumbered Figure 32.1 International Evidence of Monetary Neutrality Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers