Question

How do changes in monetary policies affect aggregate demand and aggregate supply?

Answer 1

The sum of consumer expenditure, government spending, production, and net exports is aggregate demand (AD). The AD curve assumes there is fixed money supply. The decrease in the money supply is mirrored by an equal decrease in nominal output, otherwise known as GDP. The fall in the money supply will lead to a reduction in consumer spending. This lowering will move the AD curve to the left. An equivalent increase in nominal output, or Gross Domestic Product (GDP), is reflected in the rise in money supply. The increase in money supply will result in increased consumer expenditure. This increase will have the AD curve shifted to the right.

Contractionary monetary policy decreases the supply of money within an economy. The decrease in the money supply is mirrored by an equal decrease in nominal output, otherwise known as GDP. Furthermore, the fall in the money supply would lead to a drop in consumer spending. This decrease would move the curve of aggregate demand to the left. This reduction in the money supply reduces the price levels and the real output, as the economic system has less capital available.

Expansionary monetary policy is increasing the supply of money within an economy. An equivalent increase in nominal output, or Gross Domestic Product (GDP), is reflected in the rise in money supply. Increasing the money supply will also lead to an increase in consumer spending. This rise would move the curve of aggregate demand to the right. Expansionary policies seek to promote the growth of aggregate demand. Aggregate demand, as you might remember, is the amount of private consumption , production, government expenditure and imports. The first two elements are concentrated in monetary policy. The central bank encourages private consumption by increasing the amount of money within the economy. Increasing the supply of money also lowers the interest rate which encourages lending and investment. The rise in consumption and investment leads to increased aggregate demand.

Contractionary policies seek to slow the growth of aggregated demand. Aggregate demand, as you might remember, is the amount of private consumption , production, government expenditure and imports. The first two elements are concentrated in monetary policy. The central bank discourages private consumption by cutting the amount of money in the economy. Increasing the supply of money also increases the interest rate which discourages loans and investment. The higher rate of interest also encourages investment, which also discourages private consumption. The decrease in consumption and investment causes aggregate demand to decrease in growth.