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.
a. In a correctly labeled graph, show equilibrium in the money
market.
b. In a correctly labeled AD/AS graph, show the current short-run
equilibrium in the macroeconomy.
c. In response to this high inflation rate, should the Fed engage in
expansionary or contractionary monetary policy?
d. In your graph from part a), show the impact of this monetary
policy in the money market and on the equilibrium interest rate.
e. In your graph from part b), show the impact of this monetary
policy on real GDP and the price level.
Initial Graphs
Agg.
Price
Level
MS
LRAS
AD
SRAS
E
P1
r1
0
M1
0
YP
Y1
Real GDP
After Contractionary Policy
MS2
MS1
Agg.
Price
Level
LRAS
AD
SRAS
AD2
E
P1
P2
r2
E2
r1
0
M2
M1
0
YP
Y1
Real GDP
Monetary Policy and Interest
Rates
Short-run v. Long-run Effects
Krugman, Modules 31 & 32
Expansionary Monetary Policy
Chain of Events:
1. The Fed observes that the economy is in a
recessionary gap.
2. The Fed increases the money supply.
3. The interest rate falls.
4. Investment and consumption increase.
5. AD shifts to the right.
6. Real GDP increases, unemployment rate
decreases, the aggregate price level rises.
Contractionary Monetary Policy
Chain of Events:
1. The Fed observes that the economy is in a
inflationary gap.
2. The Fed decreases the money supply.
3. The interest rate increases.
4. Investment and consumption decrease.
5. AD shifts to the left.
6. 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