Question

Starting at macroeconomic equilibrium at full employment, show the effect of completely expected expansionary monetary policy using an aggregate demand–aggregate supply (AD–AS) model and discuss.

Answer 1

Monetary policy is that policy which is made/implemented by the monetary authority (central bank) of a country which amis to effect the GDP or growth of the country by changing the money supply or interest rate. Expansionary monetary policy involves cutting interest rates or increasing the money supply to boost economic activity. It aims to increase aggregate demand and economic growth in the economy.

When the economy is in macroeconomic equilibrium at full employment, it means that all the resources of the economy are fully employed and hence there is no unemoyed resources left in the economy. Now if we adopt expansionary monetary policy at this point, increased money supply will increase the aggregate demand but supply can't be increased so it only leads to the increase in Price and hence inflation increases.

This can be graphically seen as -

In the figure AS is the aggregate supply curve which becomes vertical at point e, corresponding to the Yf which is full employment equilibrium level of income.

But due to expansionary monetary policy, aggregate demand increases from AD to AD1, which intersects AS at e1 and at this point the new price level is P1 which is greater than P. After point e any increase in aggregate demand will only increase the price level.