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The effect of monetary policy on aggregate demand

Monetary policy affects interest rates and the available quantity of loanable funds, which in turn affects several components of aggregate demand. Tight or contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will reduce two components of aggregate demand. Business investment will decline because it is less attractive for firms to borrow money, and even firms that have money will notice that, with higher interest rates, it is relatively more attractive to put those funds in a financial investment than to make an investment in physical capital. In addition, higher interest rates will discourage consumer borrowing for big-ticket items like houses and cars. Conversely, loose or expansionary monetary policy that leads to lower interest rates and a higher quantity of loanable funds will tend to increase business investment and consumer borrowing for big-ticket items.

If the economy is suffering a recession and high unemployment, with output below potential GDP    , expansionary monetary policy can help the economy return to potential GDP. [link] (a) illustrates this situation. This example uses a short-run upward-sloping Keynesian aggregate supply curve (SRAS). The original equilibrium during a recession of E 0 occurs at an output level of 600. An expansionary monetary policy will reduce interest rates and stimulate investment and consumption spending, causing the original aggregate demand curve (AD 0 ) to shift right to AD 1 , so that the new equilibrium (E 1 ) occurs at the potential GDP level of 700.

Expansionary or contractionary monetary policy

The graph showing how changes in the money supply can restore output levels to potential GDP in times of economic instability.
(a) The economy is originally in a recession with the equilibrium output and price level shown at E 0 . Expansionary monetary policy will reduce interest rates and shift aggregate demand to the right from AD 0 to AD 1 , leading to the new equilibrium (E 1 ) at the potential GDP level of output with a relatively small rise in the price level. (b) The economy is originally producing above the potential GDP level of output at the equilibrium E 0 and is experiencing pressures for an inflationary rise in the price level. Contractionary monetary policy will shift aggregate demand to the left from AD 0 to AD 1 , thus leading to a new equilibrium (E 1 ) at the potential GDP level of output.

Conversely, if an economy is producing at a quantity of output above its potential GDP, a contractionary monetary policy can reduce the inflationary pressures for a rising price level. In [link] (b), the original equilibrium (E 0 ) occurs at an output of 750, which is above potential GDP. A contractionary monetary policy will raise interest rates, discourage borrowing for investment and consumption spending, and cause the original demand curve (AD 0 ) to shift left to AD 1 , so that the new equilibrium (E 1 ) occurs at the potential GDP level of 700.

These examples suggest that monetary policy should be countercyclical    ; that is, it should act to counterbalance the business cycles of economic downturns and upswings. Monetary policy should be loosened when a recession has caused unemployment to increase and tightened when inflation threatens. Of course, countercyclical policy does pose a danger of overreaction. If loose monetary policy seeking to end a recession goes too far, it may push aggregate demand so far to the right that it triggers inflation. If tight monetary policy seeking to reduce inflation goes too far, it may push aggregate demand so far to the left that a recession begins. [link] (a) summarizes the chain of effects that connect loose and tight monetary policy to changes in output and the price level.

Questions & Answers

current economic plans (MDGS) needs
Ajijola Reply
I don't know what is happening
What is economic
Joeali Reply
What is the importance of study economics
Economic is the study of how humans make decisions in face of sacristy
economics is the study of how humans makes decision in the face of scarcity
economics is the study of human behaviour when faced with difficult situation example when goods and services are scarcity.
what is Economic
Dauda Reply
what is 4ps of economic?
thomas Reply
production place Price product
Criticism of elasticity
Siddikur Reply
what is unemployment
Gyamfi Reply
ohk thanks
why is unemployment rapid in the country
I need more explanation
what is unemployment
Munanag Reply
not working
some one who is willing qualified to work but can't find job
Bethel...explain? please
some one who is willing to work but can't find job
Yes true
which one please
unemployment refers to the ability for someone who is capable and willing to work but could not find a job..
some one who not able to find a job
please what is the secret of learning?
What is stock market?
JOHN Reply
explain the various types of cost curve
Ruth Reply
Short-run average fixed cost (SRAFC) Short-run average total cost (SRAC or SRATC) Short-run average variable cost (AVC or SRAVC) Short-run fixed cost (FC or SRFC) Short-run marginal cost (SRMC) Short-run total cost (SRTC)
what's economic development and growth
Popoola Reply
what do you understand by Ceteris Paribus?
Gabriel Reply
the external factor will remained constant, except the price
everything being equal
explain the uses of microeconomics
Nikita Reply
uses of microeconomics
Adam Smith's definition of economics
Sylvia Reply
what is economic deficit
this is a situation whereby a nation's outcome or available resources are not enough to the people thereby causing scarcity
prices of Quality demanded is equal to Quality supplied
it's quantity demand and quantity supplied that's called equilibrium
they deal With prices
define the elasticity
explain different types of elasticity
oops 😬 you are right you talk about quality I tell about quantity
elasticity is the measurement of the percentage change of one economic variable in response to a change in another
Cross Elasticity of Demand (XED) Income Elasticity of Demand (YED) Price Elasticity of Supply (PES)
anything else?
I need to know everything about theory of consumer behavior
Romy, what is microeconomic?
What is Economic please
Thomas, microeconomics is the study of how consumers, workers, and firms interact to generate outcomes in specific markets
Dauda, economics is the study of people and choices. it is on one side the study of wealth and on the more important side, a part of the study if man
How does one analyze a market where both demand and supply shift?
Gabriel Reply
That's equilibrium market
but an equlibrum can appear twice on the same market... both in Movement along the Demand/supply curve of shift in the Curve
I Mean on the same curve..
how can consumer surplus be calculated

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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