Question

c) Draw an aggregate demand and supply graph to illustrate your answer. Be sure that your graph contains the LAS curves for 2018 and 2019; SAS curves for 2018 and 2019; an AD curve for 2018 and 2019, with and without monetary policy action; and equilibrium real GDP and the price level in 2019, with and without policy.

Answer 1

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. The original equilibrium during a recession of Er 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 (AD₀) to shift right to AD₁, so that the new equilibrium (Ep) occurs at the potential GDP level of 700.