Question

Explain step by step how the Federal Reserve Bank pursing an expansionary monetary policy can lower unemployment.

Answer 1

Expansionary monetary policy is increasing the supply of money within an economy. An equal increase in nominal output, or Gross Domestic Product (GDP), is mirrored in the increase 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. Therefore, the rise in the supply of money will lead to movement up along the aggregate supply curve. This would result in higher prices and a greater potential for real output.

Expansionary policies aim to stimulate the growth of aggregate demand. Aggregate demand, as you might recall, 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.

Expansionary monetary policy would, in principle, trigger greater economic growth and lower unemployment. It will also trigger inflation to rise. The expansionary monetary policy of 2008, to some extent, helped the economic recovery. Yet, the recovery showed monetary policy weakness are weaker than expected.