Page 352 - Krugmans Economics for AP Text Book_Neat

Expansionary and Contractionary Monetary Policy
Expansionary monetary policy is
monetary policy that increases aggregate Previously we said that monetary policy shifts the aggregate demand curve. We can
demand. now explain how that works: through the effect of monetary policy on the interest rate.
Contractionary monetary policy is Suppose that the Federal Reserve expands the money supply. As we’ve seen, this
monetary policy that reduces aggregate leads to a lower interest rate. A lower interest rate, in turn, will lead to more invest-
demand. ment spending, which will lead to higher real GDP, which will lead to higher con-
sumer spending, and so on through the multiplier process. So the total quantity of
goods and services demanded at any given aggregate price level rises when the quan-
tity of money increases, and the AD curve shifts to the right. Monetary policy that
shifts the AD curve to the right, as illustrated in panel (a) of Figure 31.3, is known as
expansionary monetary policy.

figure 31.3 Monetary Policy and Aggregate Demand

(a) Expansionary Monetary Policy (b) Contractionary Monetary Policy
Aggregate Aggregate
price price
level level

AD 1 AD 2 AD 3 AD 1

Real GDP Real GDP

An expansionary monetary policy, shown in panel (a), shifts the tractionary monetary policy, shown in panel (b), shifts the ag-
aggregate demand curve to the right from AD 1 to AD 2 . A con- gregate demand curve to the left, from AD 1 to AD 3 .

Suppose, alternatively, that the Federal Reserve contracts the money supply. This leads
to a higher interest rate. The higher interest rate leads to lower investment spending,
which leads to lower real GDP, which leads to lower consumer spending, and so on. So
the total quantity of goods and services demanded falls when the money supply is re-
duced, and the AD curve shifts to the left. Monetary policy that shifts the AD curve to the
left, as illustrated in panel (b) of Figure 31.3, is called contractionary monetary policy.

Monetary Policy in Practice
We have learned that policy makers try to fight recessions. They also try to ensure price
stability: low (though usually not zero) inflation. Actual monetary policy reflects a com-
bination of these goals.
In general, the Federal Reserve and other central banks tend to engage in expansion-
ary monetary policy when actual real GDP is below potential output. Panel (a) of Fig-
ure 31.4 shows the U.S. output gap, which we defined as the percentage difference
between actual real GDP and potential output, versus the federal funds rate since 1985.
(Recall that the output gap is positive when actual real GDP exceeds potential output.)

310 section 6 Inflation, Unemployment, and Stabilization Policies