CHAPTER 23
The Monetary Policy and
Aggregate Demand Curves
LEARNING OBJECTIVES
After studying this chapter you should be able to
1. understand why there is a positive relationship between real
interest rates and inflation, the MP curve
2. illustrate how the IS curve and the MP curve can be used to derive
the aggregate demand curve featured in the aggregate demand
and supply framework in the next chapter.
P R E VIE W
In response to the subprime financial crisis in the United States, the Bank of Canada
lowered the target overnight interest rate from 4.5% in August 2007 to 0.25% in
April 2009. Moreover, for over a year (from April 1, 2009 to June 1, 2010), the
Bank of Canada also lowered the operating band for the overnight interest rate from
50 basis points to 25 basis points and instead of targeting the overnight interest rate
at the midpoint of the operating band (as it does during normal times), it targeted the
overnight rate at the bottom of the operating band, at 0.25%, thus setting an effective lower bound for the overnight interest rate.
To see how a monetary policy action like the one above affects the economy,
we need to analyze how monetary policy affects aggregate demand. We start this
chapter by explaining why monetary policymakers set interest rates to rise when
inflation increases, leading to a positive relationship between real interest rates and
inflation, which is called the monetary policy (MP) curve. Then, using the MP curve with
the IS curve we developed in the previous chapter, we derive the aggregate demand curve,
a key element in the aggregate demand/aggregate supply model framework used in
the rest of this text to discuss short-run economic fluctuations.
The Bank of Canada and Monetary Policy
Central banks throughout the world use a very short-term interest rate as their primary policy tool. In Canada, the Bank of Canada conducts monetary policy via its
setting of the overnight interest rate.
As we have seen in Chapter 17, the Bank of Canada controls the overnight rate
by varying the settlement balances (reserves) it provides to the banking system.
When it provides more reserves, banks have more money to lend to each other, and
1
M23_MISH5701_05_SE_C23.indd 1
10/15/12 7:32 PM
2
PART VI
Monetary Theory
this excess liquidity causes the overnight rate to fall. When the Bank drains reserves
from the banking system, banks have less to lend and the shortage of liquidity leads
to a rise in the overnight rate.
The overnight interest is a nominal interest rate, but as we learned in the previous chapter it is the real interest rate that affects net exports and business spending,
thereby determining the level of equilibrium output. How does the Bank of Canada’s
control of the overnight rate enable it to control the real interest rate, through which
monetary policy impacts the economy?
Recall from Chapter 4 that the real interest rate, r, is the nominal interest rate, i,
minus expected inflation, pe
(1)
r = i - pe
Changes in nominal interest rates can change the real interest rate only if actual and
expected inflation remain unchanged in the short run. Because prices typically are
slow to move—that is, they are sticky—changes in monetary policy will not have an
immediate effect on inflation and expected inflation. As a result, when the Bank
of Canada lowers the overnight interest rate, real interest rates fall; and when the
Bank of Canada raises the overnight rate, real interest rates rise.
The Monetary Policy Curve
We have now seen how the Bank of Canada can control real interest rates in the short
run. The next step in our analysis is to examine how monetary policy reacts to inflation.
The monetary policy (MP ) curve indicates the relationship between the real interest
rate the central bank sets and the inflation rate. We can write this curve as follows:
r = r + lp
where r is the autonomous component of the real interest rate set by the monetary
policy authorities, which is unrelated to the current level of the inflation rate, while
l is the responsiveness of the real interest rate to the inflation rate.
To make our discussion of the monetary policy curve more concrete, Figure 23-1
shows an example of a monetary policy curve MP in which r = 1.0 and l = 0.5:
r = 1.0 + 0.5p
(2)
At point A, where inflation is 1%, the Bank of Canada sets the real interest rate at
1.5%, while at point B, where inflation is 2%, the Bank sets the real interest rate at 2%,
and at point C, where inflation is 3%, the Bank of Canada sets the real interest rate at
2.5%. The line going through points A, B, and C is the monetary policy curve MP, and
it is upward-sloping, indicating that monetary policymakers raise real interest rates
when the inflation rate rises.
The Taylor
Principle: Why
the Monetary
Policy Curve
Has an Upward
Slope
To see why the MP curve has an upward slope, we need to recognize that central
banks seek to keep inflation stable. To stabilize inflation, monetary policymakers
follow the Taylor principle, named after John Taylor of Stanford University, in
which they raise nominal rates by more than any rise in expected inflation so that real
interest rates rise when there is a rise in inflation, as the MP curve suggests.1 John
Taylor and many other researchers have found that monetary policymakers tend to
follow the Taylor principle in practice.
1
Note that the Taylor principle differs from the Taylor rule, described in Chapter 18, because it does not provide a
rule for how monetary policy should react to conditions in the economy, while the Taylor rule does.
M23_MISH5701_05_SE_C23.indd 2
10/15/12 7:32 PM
CHAPTER 23
FIGURE 23-1
The Monetary Policy and Aggregate Demand Curves
3
The Monetary Policy Curve
The upward slope of the MP curve indicates that the central bank raises real interest rates when inflation
rises because monetary policy follows the Taylor principle.
Real
Interest
Rate, r
(%)
MP
2.5%
C
2%
B
1.5%
A
1.0%
2.0%
3.0%
Inflation Rate, p (%)
To see why monetary policymakers follow the Taylor principle, in which higher
inflation results in higher real interest rates, consider what would happen if monetary policymakers instead allowed the real interest rate to fall when inflation rose.
In this case, an increase in inflation would lead to a decline in the real interest rate,
which would increase aggregate output, in turn causing inflation to rise further,
which would then cause the real interest rate to fall even more, increasing aggregate
output. Schematically, we can write this as follows:
pc 1 r T 1 Y c 1 pc 1 r T 1 Y c 1 pc
As a result, inflation would continually keep rising and spin out of control. Indeed,
this is exactly what happened in the 1970s, when the Bank of Canada did not raise
nominal interest rates by as much as inflation rose, so that real interest rates fell.
Inflation accelerated to over 10%.2
Shifts in the MP
Curve
In common parlance, the Bank of Canada is said to tighten monetary policy when it
raises real interest rates, and to ease it when it lowers real interest rates. It is important,
however, to distinguish between changes in monetary policy that shift the monetary
policy curve, which we call autonomous changes, and the Taylor principle–driven
changes which are reflected as movements along the monetary policy curve, which
are called automatic adjustments to interest rates.
Central banks may make autonomous changes to monetary policy for various
reasons. They may wish to change the inflation rate from its current value. For
2
In a web appendix to Chapter 24 we formally demonstrate the instability of inflation when central banks do not
follow the Taylor principle.
M23_MISH5701_05_SE_C23.indd 3
10/15/12 7:32 PM
4
PART VI
Monetary Theory
example, to lower inflation they could increase r by one percentage point, and so
raise the real interest rate at any given inflation rate, what we will refer to as an
autonomous tightening of monetary policy. This autonomous monetary tightening
would shift the monetary policy curve upward by one percentage point from MP1 to
MP2 in Figure 23-2, thereby causing the economy to contract and inflation to fall.
Or, the banks may have information above and beyond what is happening to inflation that suggests interest rates must be adjusted to achieve good economic outcomes. For example, if the economy is going into a recession, monetary policymakers
would want to lower real interest rates at any given inflation rate, an autonomous
easing of monetary policy, in order to stimulate the economy and also to prevent
inflation from falling. This autonomous easing of monetary policy would result in a
downward shift in the monetary policy curve, say, by one percentage point from
MP1 to MP3 in Figure 23-2.
We contrast these autonomous changes with automatic, Taylor principle–driven
changes, a central bank’s normal response (also known as an endogenous response)
of raising real interest rates when inflation rises. These changes to interest rates
do not shift the monetary policy curve, and so cannot be considered autonomous
tightening or easing of monetary policy. Instead, they are reflected in movements
along the monetary policy curve.
The distinction between autonomous monetary policy changes and movements along the monetary policy curve is illustrated by the monetary policy actions
the Bank of Canada took at the onset of the 2007–2009 financial crisis in the fall
of 2007.
FIGURE 23-2
Shifts in the Monetary Policy Curve
Autonomous changes in monetary policy, such as when a central bank changes the real interest rate at
any given inflation rate, shift the MP curve. An autonomous tightening of monetary policy that increases
the real interest rate shifts the MP curve up to MP2, whereas an autonomous easing of monetary policy
that lowers the real interest rate shifts the MP curve down to MP3.
Real
Interest
Rate, r
(%)
MP2
Autonomous monetary policy
tightening shifts the MP curve up.
MP1
3.5%
C
MP3
3.0%
2.5%
B
2.0%
Autonomous monetary
policy easing shifts the
MP curve down.
1.5%
A
1.0%
0.5%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
4.0%
Inflation Rate, p (%)
M23_MISH5701_05_SE_C23.indd 4
10/15/12 7:32 PM
CHAPTER 23
The Monetary Policy and Aggregate Demand Curves
5
APPLICATION
Autonomous Monetary Easing at the Onset
of the 2007–2009 Financial Crisis
When the financial crisis started in August 2007, inflation was rising and economic
growth was quite strong. Yet the Bank of Canada began an aggressive easing, lowering the overnight interest rate as shown in Figure 23-3. What does this tell us about
effects on the monetary policy curve?
FIGURE 23-3
The Inflation Rate and the Overnight Interest Rate, 2007–2011
The Bank of Canada began an aggressive autonomous easing of monetary policy in September 2007,
bringing down its policy rate, the target overnight interest rate, despite the continuing high inflation.
5%
The Inflation Rate and the
Overnight Interest Rate (% annual rate)
Overnight interest rate
4%
3%
2%
Inflation rate
1%
0%
2007
2008
2009
2010
2011
–1%
–2%
Year
A movement along the MP curve would have suggested that the Bank of Canada
would continue to keep hiking interest rates because inflation was rising, but instead
it did the opposite. The Bank thus shifted the monetary policy curve down from
MP1 to MP3, as in Figure 23-2. The Bank pursued this autonomous monetary policy
easing because the negative shock to the economy from the disruption to financial
markets (discussed in Chapter 9) indicated that, despite current high inflation rates,
the economy was likely to weaken in the near future and the inflation rate would fall.
Indeed, this is exactly what came to pass, with the economy going into recession in
December 2007 and the inflation rate falling sharply after August 2008.
The Aggregate Demand Curve
We are now ready to derive the relationship between the inflation rate and aggregate
output when the goods market is in equilibrium, the aggregate demand curve. The
MP curve we developed demonstrates how central banks respond to changes in inflation with changes in interest rates, in line with the Taylor principle. The IS curve we
developed in Chapter 22 showed that changes in real interest rates, in turn, affect
equilibrium output. With these two curves, we can now link the quantity of aggregate
M23_MISH5701_05_SE_C23.indd 5
10/15/12 7:32 PM
6
PART VI
Monetary Theory
output demanded with the inflation rate, given the public’s expectations of inflation and the stance of monetary policy. The aggregate demand curve is central to the
aggregate demand and supply analysis we develop further in the next chapter, which
allows us to explain short-run fluctuations in both aggregate output and inflation.
Deriving the
Aggregate
Demand Curve
Graphically
Using the hypothetical MP curve from Equation 2, we know that when the inflation rate
rises from 1% to 2% to 3%, real interest rates rise from 1.5% to 2% to 2.5%. We plot
these points in panel (a) of Figure 23-4 to create the MP curve. In panel ( b), we graph
the IS curve described in Equation 13 of Chapter 22 (Y = 12 - r ). As the real interest rate rises from 1.5% to 2% to 2.5%, the equilibrium moves from point 1 to point 2
to point 3 and aggregate output falls from $10.5 trillion to $10 trillion to $9.5 trillion.
In other words, as real interest rates rise, investment and net exports decline, leading
to a reduction in aggregate demand. Panels (a) and (b) demonstrate that as inflation
rises from 1% to 2% to 3%, the equilibrium moves from point 1 to point 2 to point 3
in panel (c), and aggregate output falls from $10.5 trillion to $10 trillion to $9.5 trillion.
The line that connects the three points in panel (c) is the aggregate demand curve,
AD, and it indicates the level of aggregate output corresponding to each of the three
real interest rates consistent with equilibrium in the goods market for any given inflation rate. The aggregate demand curve has a downward slope, because a higher inflation
rate leads the central bank to raise real interest rates, thereby lowering planned spending, and hence lowering the level of equilibrium aggregate output.
By using some algebra (see the FYI box, “Deriving the Aggregate Demand Curve
Algebraically”), the AD curve in Figure 23-4 can be written numerically as follows:
Y = 11 - 0.5p
Factors That
Shift the
Aggregate
Demand Curve
(3)
Movements along the aggregate demand curve describe how the equilibrium level of
aggregate output changes when the inflation rate changes. When factors besides the
inflation rate change, however, the aggregate demand curve can shift. We first review the
factors that shift the IS curve, and then consider other factors that shift the AD curve.
FIGURE 23-4
Deriving the AD Curve
The MP curve in panel (a) shows that as inflation rises from 1.5% to 2% to 3.0%, the real interest rate
rises from 1.5% to 2.0% to 2.5%. The IS curve in panel ( b) then shows that higher real interest rates lead
to lower planned investment spending, and hence aggregate output falls from $10.5 trillion to $10 trillion
to $9.5 trillion. Finally, panel (c) plots the level of equilibrium output corresponding to each of the three
inflation rates: the line that connects these points is the AD curve, and it is downward sloping.
(a) MP Curve
Real
Interest
Rate, r
(%)
Step 1. The MP curve links the
inflation rate to the real interest rate
level set by the central bank.
MP
3
2.5%
2
2.0%
1
1.5%
1.0%
2.0%
3.0%
Inflation Rate, p (%)
M23_MISH5701_05_SE_C23.indd 6
10/15/12 7:32 PM
CHAPTER 23
The Monetary Policy and Aggregate Demand Curves
7
(b) IS Curve
Real
Interest
Rate, r
(%)
3
Step 2. The IS curve links the
real interest rate level from the
MP curve to equilibrium output.
2.5%
2
2.0%
1
1.5%
IS
9.5
10.0
10.5
Aggregate Output, Y ($ trillions)
(c) Aggregate Demand Curve
Inflation
Rate, p
(%)
Step 3. The AD curve
links the inflation rate
from the MP curve to
equilibrium output.
3
3.0%
2
2.0%
1
1.0%
AD
9.5
10.0
10.5
Aggregate Output, Y ($ trillions)
We saw in the previous chapter that six factors cause
the IS curve to shift. It turns out that the same factors cause the aggregate demand
curve to shift as well:
SHIFTS IN THE IS CURVE
1.
2.
3.
4.
5.
6.
Autonomous consumption expenditure
Autonomous investment spending
Government purchases
Taxes
Autonomous net exports
Financial frictions
We examine how changes in these factors lead to a shift in the aggregate demand
curve in Figure 23-5.
Figure 23-5 shows that any factor that shifts the IS curve shifts the aggregate
demand curve in the same direction. Therefore, “animal spirits” that encourage a
rise in autonomous consumption expenditure or planned investment spending, a
rise in government purchases, an autonomous rise in net exports, a fall in taxes, or
a decline in financial frictions—all of which shift the IS curve to the right—will also
shift the aggregate demand curve to the right. Conversely, a fall in autonomous consumption expenditure, a fall in planned investment spending, a fall in government
M23_MISH5701_05_SE_C23.indd 7
10/15/12 7:32 PM
8
PART VI
Monetary Theory
FIGURE 23-5
Shift in the AD Curve from Shifts in the IS Curve
At a 2% inflation rate in panel (a), the monetary policy curve indicates that the real interest rate is 2%. An
increase in government purchases shifts the IS curve to the right in panel ( b). At a given inflation rate and
real interest rate of 2.0%, equilibrium output rises from $10 trillion to $12.5 trillion, which is shown as a
movement from point A1 to point A2 in panel (c), shifting the aggregate demand curve to the right from
AD1 to AD2. Any factor that shifts the IS curve shifts the AD curve in the same direction.
(a) MP Curve
Real
Interest
Rate, r
(%)
Step 1. The MP curve links the
inflation rate to the real interest rate
level set by the central bank.
MP
A
2.0%
2.0%
Inflation Rate, p (%)
(b) IS Curve
Real
Interest
Rate, r
(%)
2.0%
Step 2. A rise in government purchases
increases equilibrium output, shifting
the IS curve rightward . . .
A1
A2
IS2
IS1
10.0
12.5
Aggregate Output, Y ($ trillions)
(c) Aggregate Demand Curve
Inflation
Rate, p
(%)
2.0%
Step 3. and shifting the
AD curve rightward.
A1
A2
AD2
AD1
10.0
12.5
Aggregate Output, Y ($ trillions)
M23_MISH5701_05_SE_C23.indd 8
10/15/12 7:32 PM
CHAPTER 23
The Monetary Policy and Aggregate Demand Curves
9
FYI
Deriving the Aggregate Demand Curve Algebraically
To derive the numerical AD curve, we start by taking the numerical IS curve, Equation 13, from the
previous chapter,
Y = 12 - r
and then substitute in for r from the numerical MP
curve in Equation 2, r = 1.0 + 0.5p, to yield
Y = 12 - (1.0 + 0.5p)
= (12 - 1) - 0.5p
= 11 - 0.5p
Y = [C + I - d f + G + N X - mpc * T ]
1
d + x
*
* r
1 - mpc
1 - mpc
and then substitute for r from the algebraic MP
curve in Equation 1, r = r + lp, to yield the
more general AD curve:
Y = [ C + I - d f + G + N X - mpc * T ]
1
d + x
*
* ( r + lp) (4)
1 - mpc
1 - mpc
as in the text.
Similarly, we can derive a more general version
of the AD curve, using the algebraic version of the
IS curve from Equation 12 in Chapter 22:
purchases, a fall in net exports, a rise in taxes, or a rise in financial frictions will cause
the aggregate demand curve to shift to the left.
We now examine what happens to the aggregate
demand curve when the MP curve shifts. Suppose that the Bank of Canada decides
to autonomously tighten monetary policy by raising the real interest rate by one percentage point at any given level of the inflation rate because it is worried about the
economy overheating. At an inflation rate of 2.0%, the real interest rate rises from
2.0% to 3.0% in Figure 23-6. The MP curve shifts up from MP1 to MP2 in panel (a).
SHIFTS IN THE MP CURVE
FIGURE 23-6
Shifts in the AD Curve from Autonomous Monetary Policy Tightening
Autonomous monetary tightening that raises real interest rates by one percentage point at any given inflation rate shifts the MP curve up from MP1 to MP2 in panel (a). With the inflation rate at 2.0%, the higher
3% interest rate results in a movement from point A1 to A2 on the IS curve, with output falling from
$10 trillion to $9 trillion. This change in equilibrium output leads to movement from point A1 to point A2
in panel (c), shifting the aggregate demand curve to the left from AD1 to AD2.
(a) MP
Real
Interest
Rate, r
(%)
3.0%
2.0%
Step 1. Autonomous monetary policy
tightening increases the real interest rate . . .
MP2
MP1
A2
A1
2.0%
Inflation Rate, p (%)
(Continued )
M23_MISH5701_05_SE_C23.indd 9
10/15/12 7:32 PM
10
PART VI
Monetary Theory
FIGURE 23-6
(Continued )
(b) IS
Real
Interest
Rate, r
(%)
A2
3.0%
Step 2. causing movement
along the IS curve, decreasing
equilibrium output . . .
A1
2.0%
IS
9.0
10.0
Aggregate Output, Y ($ trillions)
(c) Aggregate Demand
Inflation
Rate, p
(%)
Step 3. and shifting
the AD curve leftward.
A2
2.0%
A1
AD1
AD2
9.0
10.0
Aggregate Output, Y ($ trillions)
FYI
The Zero Lower Bound and Nonconventional Monetary Policy
As policy rates around the world have reached the
zero lower bound in recent years, central banks
are in a liquidity trap, unable to lower them further. Moreover, central banks have lost their usual
ability to signal policy changes via changes in the
policy rate and to lower long-term interest rates by
lowering short-term interest rates.
With the policy rate at the zero lower bound, a
decoupling of long- and short-term interest rates,
and the possibility of a deflationary trap (that is,
extremely low nominal interest rates and sustained
deflation), central banks have departed from the
M23_MISH5701_05_SE_C23.indd 10
traditional interest-rate targeting approach to
monetary policy and are now considering new
tools to steer their economies. As we discussed
in Chapter 17, the Bank of Canada has identified
three alternative instruments that it would consider using in an environment with low short-term
(nominal) interest rates: forward guidance, quantitative easing, and credit easing. That is, central
banks are switching from the “one tool, one target” mode of operation and are searching for new
tools to steer their economies in an environment
with interest rates at or near zero.
10/15/12 7:33 PM
CHAPTER 23
The Monetary Policy and Aggregate Demand Curves
11
Panel (b) shows that when the inflation rate is at 2.0%, the higher interest rate results
in the equilibrium moving from point A1 to A2 on the IS curve, with output falling
from $10 trillion to $9 trillion. The lower output of $9 trillion occurs because the
higher real interest leads to a decline in investment and net exports, which lowers
aggregate demand. The lower output of $9 trillion then decreases the equilibrium
output level from point A1 to point A2 in panel (c), and so the AD curve shifts to the
left from AD1 to AD2.
Our conclusion from Figure 23-6 is that an autonomous tightening of monetary
policy—that is, a rise in the real interest rate at any given inflation rate—shifts the
aggregate demand curve to the left. Similarly, an autonomous easing of monetary
policy shifts the aggregate demand curve to the right.
We have now derived and analyzed the aggregate demand curve—an essential
element in the aggregate demand and supply framework that we examine in the next
chapter. We will use the aggregate demand curve in this framework to determine
both aggregate output and inflation, as well as to examine events that cause these
variables to change.
MyEconLab
MyEconLab is an online homework and tutorial system that puts you in control of your own
learning with study and practice tools directly correlated to this chapter’s content. Visit
MyEconLab to explore the following resources:
• All of the Applied Problems marked in green are available in the Study Plan on MyEconLab for further practice. You will
also find the answers to the questions marked with an asterisk in the Student Resources section of your MyEconLab.
MyEconLab also features Additional Readings, videos, Glossary Flashcards, Audio Chapter Summaries, Economics News
Feeds, Animations, and many additional tools to help you master key concepts from the text.
SUMMARY
1. When the Bank of Canada lowers the overnight interest
rate by providing more liquidity to the banking system, real
interest rates fall in the short run; and when the Bank of
Canada raises the overnight rate by reducing the liquidity in
the banking system, real interest rates rise in the short run.
2. The monetary policy (MP ) curve shows the relationship
between inflation and the real interest rate arising from
monetary authorities’ actions. Monetary policy follows the
Taylor principle, in which higher inflation results in higher
real interest rates, as represented by a movement up along
the monetary policy curve. An autonomous tightening of
monetary policy occurs when monetary policymakers raise
the real interest rate at any given inflation rate, resulting
in an upward shift in the monetary policy curve. An
autonomous easing of monetary policy and a downward
shift in the monetary policy curve occurs when monetary
policymakers lower the real interest rate at any given inflation rate.
3. The aggregate demand curve tells us the level of equilibrium aggregate output (which equals the total quantity of
output demanded) for any given inflation rate. It slopes
downward because a higher inflation rate leads the central
bank to raise real interest rates, which leads to a lower level
of equilibrium output. The aggregate demand curve shifts
in the same direction as a shift in the IS curve; hence it
shifts to the right when government purchases increase,
taxes decrease, “animal spirits” encourage consumer and
business spending, autonomous net exports increase, or
financial frictions decrease. An autonomous tightening of
monetary policy—that is, an increase in real interest rates
at any given inflation rate—leads to a decline in aggregate
demand and the aggregate demand curve shifts to the left.
KEY TERMS
aggregate demand curve, p. xx
autonomous easing of monetary
policy, p. xx
M23_MISH5701_05_SE_C23.indd 11
autonomous tightening of monetary
policy, p. xx
liquidity trap, p. xx
monetary policy (MP ) curve, p. xx
Taylor principle, p. xx
10/15/12 7:33 PM
12
PART VI
Monetary Theory
QUESTIONS
1. When the inflation rate increases, what happens to the
overnight interest rate? Operationally, how does the
Bank of Canada adjust the overnight interest rate?
12. How does an autonomous tightening or easing of monetary policy by the Bank of Canada affect the aggregate
demand curve?
2. What is the key assumption underlying the Bank of
Canada's ability to control the real interest rate?
13. For each of the following, describe how (if at all), the IS
curve, MP curve, and AD curves are affected.
3. Why is it necessary for the MP curve to have an upward
slope?
4. If l = 0, what does that imply about the relationship
between the nominal interest rate and the inflation rate?
5. How does an autonomous tightening or easing of monetary policy by the Bank of Canada affect the MP curve?
6. How is an autonomous tightening or easing of monetary
policy different from a change in the real interest rate due
to a change in the current inflation rate?
7. Suppose that a new Bank of Canada governor is appointed, and his or her approach to monetary policy can
be summarized by the following statement: “I care only
about increasing employment; inflation has been at very
low levels for quite some time; my priority is to ease monetary policy to promote employment.” How would you
expect the monetary policy curve to be affected, if at all?
8. “The Bank of Canada decreased the overnight interest rate
in late 2007, even though inflation was increasing. This
demonstrates a violation of the Taylor principle.” Is this
statement true, false, or uncertain? Explain your answer.
9. What factors affect the slope of the aggregate demand
curve?
10. “Autonomous monetary policy is more effective at
changing output when l is higher” Is this statement true,
false, or uncertain? Explain your answer.
11. If net exports were not sensitive to changes in the real
interest rate, would monetary policy be more—or less—
effective in changing output?
a.
b.
c.
d.
e.
f.
A decrease in financial frictions.
An increase in taxes, and an autonomous easing of
monetary policy.
An increase in the current inflation rate.
A decrease in autonomous consumption.
Firms become more optimistic about the future of
the economy.
The new Bank of Canada governor begins to care
more about fighting inflation.
14. What would be the effect of an increase in Canadian
net exports on the aggregate demand curve? Would an
increase in net exports affect the monetary policy curve?
Explain why or why not.
15. Why does the aggregate demand curve shift when “animal spirits” change?
16. If government spending increases while taxes are raised
to keep the budget balanced, what happens to the aggregate demand curve?
17. Suppose that government spending is increased at
the same time that an autonomous monetary policy
tightening occurs. What will happen to the position of
the aggregate demand curve?
18. “If f increases, then the Bank of Canada can keep output constant by reducing the real interest rate by the
same amount as the increase in financial frictions.” Is
this statement true, false, or uncertain? Explain your
answer.
APPLIED PROBLEMS
19. Assume the monetary policy curve is given by r =
1.5 + 0.75 p.
a.
b.
c.
d.
Calculate the real interest rate when the inflation
rate is 2%, 3%, and 4%.
Draw the graph of the MP curve, labeling the points
from part (a).
Assume now that the monetary policy curve is
r = 2.5 + 0.75 p. Does the new monetary policy
curve represent an autonomous tightening or loosening of monetary policy?
Calculate the real interest rate when the inflation
rate is 2%, 3%, and 4%, and draw the new MP curve
showing the shift from part (b).
M23_MISH5701_05_SE_C23.indd 12
20. Use an IS curve and an MP curve to derive graphically
the AD curve.
21. Suppose the monetary policy curve is given by r =
1.5 + 0.75 p, and the IS curve is Y = 13 - r .
a.
b.
c.
Calculate an expression for the aggregate demand
curve.
Calculate the real interest rate and aggregate output
when the inflation rate is 2%, 3%, and 4%.
Draw graphs of the IS, MP, and AD curves, labelling the points in the appropriate graphs from
part (b) above.
10/15/12 7:33 PM
CHAPTER 23
22. Consider an economy described by the following:
C
I
G
T
NX
f
mpc
d
x
l
r
=
=
=
=
=
=
=
=
=
=
=
a.
b.
Derive expressions for the MP curve and AD curve.
Calculate the real interest rate and aggregate output
when p = 2 and p = 4.
Draw a graph of the MP curve and AD curve, indicating the points in part (b) above.
c.
4 trillion
1.5 trillion
3.0 trillion
3.0 trillion
1.0 trillion
0
0.8
0.35
0.15
0.5
2
23. Consider an economy described by the following:
C
I
G
T
NX
f
mpc
d
x
l
r
=
=
=
=
=
=
=
=
=
=
=
3.25 trillion
1.3 trillion
3.5 trillion
3.0 trillion
- 1.0 trillion
1
0.75
0.3
0.1
1
1
The Monetary Policy and Aggregate Demand Curves
a.
b.
c.
d.
13
Derive expressions for the MP curve and AD curve.
Assume that p = 1. What is the real interest rate,
equilibrium level of output, consumption, planned
investment, and net exports?
Suppose the Bank of Canada increases r to r = 2
Calculate what happens to the real interest rate,
equilibrium level of output, consumption, planned
investment, and net exports.
Considering that output, consumption, planned investment, and net exports all decreased in part (c),
why might the Bank choose to increase r ?
24. Consider the economy described in Applied Problem 23.
a.
b.
c.
d.
Derive expressions for the MP curve and AD curve.
Assume that p = 2. What is the real interest rate
and equilibrium level of output?
Suppose government spending increases to $4 trillion. What happens to equilibrium output?
If the Bank of Canada wanted to keep output constant, then what monetary policy change should
occur?
25. Suppose the MP curve is given as r = 2 + p, and the IS
curve is given as Y = 20 - 2r .
a.
b.
c.
Derive an expression for the AD curve, and draw a
graph labeling points at p = 0, p = 4, and p = 8.
Suppose that l increases to l = 2. Derive an
expression for the new AD curve, and draw the
new AD curve using the graph from part (a).
What does your answer to part ( b) say about the
relationship between a central bank’s distaste for
inflation and the slope of the AD curve?
WEB EXERCISES
1. Go to http://www.bankofcanada.ca/monetary-policyintroduction/. Review what the Bank of Canada says
M23_MISH5701_05_SE_C23.indd 13
its goals are for monetary policy. Explain why these are
consistent with the Taylor principle.
10/15/12 7:33 PM