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Monetary Policy and Total Expenditure
The effect of interest rates on spending provides the chief mechanism by which monetary F I GU R E 5
policy affects the macroeconomy. We know from our analysis of the market for bank re-
The Effect of Interest
serves (repeated in Figure 4) that monetary policy can move interest rates up or down. Let Rates on Total
us, therefore, trace the impacts of monetary policy, starting there. Expenditure
Suppose the Federal Reserve, worried that the
economy might slip into a recession, increases the
supply of bank reserves. It would normally do so 45°
by purchasing government securities in the open
market, thereby shifting the supply schedule for C + I + G + (X “ IM)
reserves outward”as indicated by the shift from (lower interest rate)
the black line S0S0 to the brick-colored line S1S1
Real Expenditure

C + I + G + (X “ IM)
in Figure 4(a). This is essentially what the Fed did
in 2007 and 2008.
C + I + G + (X “ IM)
With the demand schedule for bank reserves, (higher interest rate)
DD, temporarily fixed, such a shift in the supply
curve has the effect that an increase in supply al-
ways has in a free market: It lowers the price, as
Figure 4(a) shows. In this case, the relevant price is
the rate of interest that must be paid for borrowing
reserves, r (the federal funds rate). So r falls.
Next, for reasons we have just outlined, invest-
ment spending on housing and business equipment
Real GDP
(I) rises in response to the lower interest rates. But,

See, for example, Chapter 7, pages 138“139.

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Part 3
272 Fiscal and Monetary Policy

as we learned in Chapter 9, such an autonomous rise in investment kicks off a multiplier
chain of increases in output and employment.
This sequence of events summarizes the linkages from the supply of bank reserves to
the level of aggregate demand. In brief, monetary policy works as follows:
Expansionary monetary policy leads to lower interest rates (r), and these lower interest
rates encourage investment (I), which has multiplier effects on aggregate demand.
This process operates equally well in reverse. By contracting bank reserves and the
money supply, the central bank can push interest rates up, which is precisely what the Fed
did between mid-2004 and August 2006. Higher rates will cause investment spending to
fall and pull down aggregate demand via the multiplier mechanism.
This, in outline form, is how monetary policy influences the economy in the Keynesian
model. Because the chain of causation is fairly long, the following schematic diagram may
help clarify it:

1 2 3 4
Federal Reserve M and r C + I + G + (X “ I M) GDP

In this causal chain, Link 1 indicates that the Federal Reserve™s open-market operations
affect both interest rates and the money supply. Link 2 stands for the effect of interest rates
on investment. Link 3 simply notes that investment is one component of total spending.
Link 4 is the multiplier, relating an autonomous change in investment to the ultimate
change in aggregate demand. To see what econo-
mists must study if they are to estimate the effects of
monetary policy, let us briefly review what we know
45° about each of these four links.
Link 1 is the subject of this chapter. It was de-
C + I1 + G + (X “ IM)
picted in Figure 4(a), which shows how injections of
C + I0 + G + (X “ IM)
bank reserves by the Federal Reserve push the inter-
Real Expenditure

est rate down. Thus, the first thing an economist
must know is how sensitive interest rates are to
changes in the supply of bank reserves.
Link 2 translates the lower interest rate into
higher investment spending. To estimate this effect
in practice, economists must study the sensitivity of
investment to interest rates”a topic we first took up
in Chapter 7.
Link 3 instructs us to enter the rise in I as an au-
tonomous upward shift of the C 1 I 1 G 1 (X 2 IM)
5,500 6,000 6,500 7,000
schedule in a 45° line diagram. Figure 6 carries out
Real GDP
this next step. The expenditure schedule rises from
F I GU R E 6 C 1 I0 1 G 1 (X 2 IM) to C 1 I1 1 G 1 (X 2 IM).
NOTE: Figures are in billions of dollars per year.

Finally, Link 4 applies multiplier analysis to this
The Effect of
Expansionary vertical shift in the expenditure schedule to obtain the eventual increase in real GDP de-
Monetary Policy on manded. This change is shown in Figure 6 as a shift in equilibrium from E0 to E1, which
Total Expenditure
raises real GDP by $500 billion in the example. Of course, the size of the multiplier itself
must also be estimated. To summarize:
The effect of monetary policy on aggregate demand depends on the sensitivity of inter-
est rates to open-market operations, on the responsiveness of investment spending to
the rate of interest, and on the size of the basic expenditure multiplier.

Our analysis up to now leaves one important question unanswered: What happens to the
price level? To find the answer, we must recall that aggregate demand and aggregate sup-
ply jointly determine prices and output. Our analysis of monetary policy so far has shown

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Chapter 13 273
Managing Aggregate Demand: Monetary Policy

us how expansionary monetary policy boosts total spending: It increases the aggregate F I GU R E 7
quantity demanded at any given price level. But to learn what happens to the price level and The Inflationary Effects
to real output, we must consider aggregate supply as well. of Expansionary
Specifically, when considering shifts in aggregate de- Monetary Policy
mand caused by fiscal policy in Chapter 11, we noted that an
upsurge in total spending normally induces firms to in- D1
crease output somewhat and to raise prices somewhat. This
is precisely what an upward-sloping aggregate supply
curve shows. Whether the responses come more in the form S
$500 billion
of real output or more in the form of price depends on the
slope of the aggregate supply curve (see Figure 7). Exactly B

Price Level
the same analysis of output and price responses applies to
monetary policy or, for that matter, to anything that raises E
the aggregate demand curve. So we conclude that 100

Expansionary monetary policy causes some inflation
under normal circumstances. But exactly how much in-
flation it causes depends on the slope of the aggregate
supply curve.
The effect of expansionary monetary policy on the price
6,000 6,400
level is shown graphically on an aggregate supply and
Real GDP
demand diagram in Figure 7. In the example depicted in
Figure 6, the Fed™s actions lowered interest rates enough to
NOTE: GDP figures are in billions of dollars per year.
increase aggregate demand (through the multiplier) by
$500 billion. We enter this increase as a $500 billion horizontal shift of the aggregate de-
mand curve in Figure 7, from D0D0 to D1D1. The diagram shows that this expansionary
monetary policy pushes the economy™s equilibrium from point E to point B”the price
level therefore rises from 100 to 103, or 3 percent. The diagram also shows that real GDP
rises by only $400 billion, which is less than the $500 billion stimulus to aggregate de-
mand. The reason, as we know from earlier chapters, is that rising prices stifle real aggre-
gate demand.
By taking account of the effect of an increase in the money supply on the price level, we
have completed our story about the role of monetary policy in the Keynesian model. We
can thus expand our schematic diagram of monetary policy as follows:

1 2 3 4
Federal Reserve M and r C + I + G + (X “ IM) Y and P

The last link now recognizes that both output and prices normally are affected by changes
in interest rates and the money supply.

Application: Why the Aggregate Demand Curve
Slopes Downward8
This analysis of the effect of monetary policy on the price level puts us in a better position
to understand why higher prices reduce aggregate quantity demanded”that is, why the
aggregate demand curve slopes downward. In earlier chapters, we explained this phe-
nomenon in two ways. First, we observed that rising prices reduce the purchasing power
of certain assets held by consumers, especially money and government bonds, and that
falling real wealth in turn retards consumption spending. Second, we noted that higher
domestic prices depress exports and stimulate imports.
There is nothing wrong with this analysis; it is just incomplete. Higher prices have
another important effect on aggregate demand, through a channel that we are now in a
position to understand.

This section contains somewhat more difficult material, which can be skipped in shorter courses.

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Licensed to:
Part 3
274 Fiscal and Monetary Policy

Bank deposits are demanded primarily to conduct transactions.
D0 D1 S
As we noted earlier in this chapter, an increase in the average
money cost of each transaction”that is, a rise in the price level”
will increase the quantity of deposits demanded, and hence in-
crease the demand for bank reserves. Thus, when spending rises
for any reason, the price level will also rise, and more reserves will
Interest Rate

therefore be demanded at any given interest rate”that is, the de-
mand curve for bank reserves will shift outward to the right, as
shown in Figure 8.
Effect of a
If the Fed does not increase the supply of reserves, this outward
higher P
shift of the demand curve will force the cost of borrowing
reserves”the federal funds rate”to rise, as Figure 8 makes clear.
As we know, increases in interest rates reduce investment and,
hence, reduce aggregate demand. This is the main reason why the
D0 D1
economy™s aggregate demand curve has a negative slope, mean-
ing that aggregate quantity demanded is lower when prices are
Bank Reserves
higher. In sum:
F I GU R E 8
At higher price levels, the quantity of bank reserves demanded is greater. If the Fed
The Effect of a Higher
holds the supply schedule fixed, a higher price level must therefore lead to higher inter-
Price Level on the
est rates. Because higher interest rates discourage investment, aggregate quantity
Market for Bank
demanded is lower when the price level is higher”that is, the aggregate demand curve
has a negative slope.

You will no doubt be relieved to hear that we have now pro-
vided just about all the technical apparatus we need to ana-
lyze stabilization policy. To be sure, you will encounter
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