What are the key differences between how we illustrate an expansionary monetary policy in the basic aggregate demand and aggregate supply model and in the dynamic aggregate demand and aggregate supply model?

The aggregate demand and supply model, often referred to simply as the AD/AS model, is a fundamental tool used to analyze the performance of an economy. Imagine the economy as a marketplace, where aggregate demand (AD) represents the total amount of goods and services that all the consumers, businesses, and government are willing to buy at different price levels, while aggregate supply (AS) refers to the total amount of goods and services that producers are willing to sell.

In the context of monetary policy, when the central bank opts for expansionary measures—like lowering interest rates—households and businesses are incentivized to borrow and spend more. This boost in spending shifts the AD curve to the right on a graph where the horizontal axis measures the output and the vertical axis represents the price level, indicating a surge in economic activity. A rightward shift typically leads to higher output and price levels, suggesting economic expansion.

The dynamic aggregate demand and supply model (DAD/DAS model) adds an additional layer of realism to the standard AD/AS model by incorporating expectations and time into the equation. Unlike the basic AD/AS model that assumes instant adjustments, the DAD/DAS model operates with the understanding that prices and wages do not immediately adapt to policy changes.

When an expansionary monetary policy is introduced, the initial reaction is similar—a shift of the DAD curve to the right. But with time, expectations about future inflation lead workers to demand higher wages, and producers anticipate higher costs. As a result, the DAS curve eventually shifts leftward, bringing the economy back to a long-term equilibrium. This model captures the transient effects on output and the more permanent impact on the price level, offering a glimpse into the interplay between short-term economic fluctuations and long-term economic trends.

Economic growth signifies an increase in the production and consumption of goods and services, leading to a rise in the standard of living over time. It is often measured by the increase in a country's real gross domestic product (GDP).

Economic growth can be spurred by various factors, including investments in capital, technological advancements, human capital development, and policy decisions. Expansionary monetary policy specifically aims to accelerate growth by making money more accessible and borrowing more affordable. This encourages spending and investment, which in turn boosts production and creates jobs. Nevertheless, it's important to balance such growth to avoid overheating the economy, which can lead to the next core concept: inflation.

Inflation is the rate at which the general level of prices for goods and services is rising, eroding purchasing power over time. A moderate inflation rate is a sign of a growing economy, as it usually accompanies an increase in demand. However, high inflation can be detrimental, leading to a loss of consumer and business confidence, and can hurt economic growth.

Under an expansionary monetary policy, the increased supply of money in the economy can lead to inflation, especially if the growth in aggregate demand outstrips the growth in aggregate supply. In our DAD/DAS model, this is represented by the leftward shift of the DAS curve following the rightward shift of the DAD curve, resulting in higher prices. Central banks must therefore carefully manage expansionary policies to nurture economic growth while keeping inflation in check.