Question

In ABCT, what is the effect of a credit expansion by the central bank? Using the ABCT framework, show the effect of a credit expansion on the macroeconomy (use the ppf, stages of production and loanable funds market graphs to show your answer graphically). (Be sure to explain verbally what you depict graphically).

Answer 1

When credit is expanded by central bank by increasing money supply and decreasing interest rates( expansionary monetary policy ). Figure a shows how changing demand can show change in interest rates. More the demand, more the interest rates and less the demand lesser the interest rate.

Figure b above show how increase in money supply will decrease interest rates and people will borrow more. Loan able funds increase with increase in money supply.

This helps aggregate demand to shift to right from AD1 to AD2 and average price levels going up from Pf to PLe. Real GDP also goes up from Yf to Ye.Refer fig. below:

If these policies are supported by proper supply side policies(Like human and physical capital improvement) then economy may shift its LRAS to right as shown below and this will be good for an economy as economic potential itself increases. This shift also means Production possibilty curve shifting outwards. However, If Aggregate supply does not increase then inflation may be severe.