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Chapter 26: Problem 2

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

Short Answer

Expert verified
In both models, contractionary monetary policy is shown as a decrease in aggregate demand - a shift to the left of aggregate demand curve. However, in the dynamic model, this policy also accounts for changes in inflation expectations leading to a shift in short-run aggregate supply or a movement along it.

Step by step solution

01

Understanding the Models

The Basic Aggregate Demand and Supply Model defines equilibrium in the economy as the point where aggregate demand equals aggregate supply. On the other hand, The Dynamic Aggregate Demand and Supply Model, taking into account inflation and growth, depicts short-run equilibrium as the interaction of aggregate demand, short-run aggregate supply, and long-run aggregate supply.
02

Contractionary Policy in Basic AD-AS model

In the basic AD-AS model, a contractionary monetary policy is shown as a shift to the left in the aggregate demand curve. This is because the policy reduces the money in circulation, elevating interest rates and reducing spending.
03

Contractionary Policy in Dynamic AD-AS model

In the dynamic AD-AS model, the same policy manifests as a movement along the short-run aggregate supply curve due to change in inflation expectations or a shift to the left of short-run aggregate supply curve when policy reduces money output. This reduces spending but also shifts lenders' and consumers' expectations.
04

Comparison of the models

While both models illustrate a decrease in aggregate demand due to contractionary monetary policy, the dynamic model additionally takes into account the change in inflation expectations. The dynamic model sees a shift in short-run aggregate supply and a movement along it due to changes in policy and economic actors' reactions, respectively.

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Most popular questions from this chapter

(Related to the Apply the Concept on page 931) Suppose you buy a house for $$\$ 150,000 .$$ One year later, the market price of the house has risen to $$\$ 165,000$$. What is the return on your investment in the house if you made a down payment of 20 percent and took out a mortgage loan for the other 80 percent? What if you made a down payment of 5 percent and borrowed the other 95 percent? Be sure to show your calculations in your answer.

Suppose that the equilibrium real federal funds rate is 2 percent and the target rate of inflation is 2 percent. Use the following information and the Taylor rule to calculate the federal funds rate target: Current inflation rate \(=4\) percent Potential \(\mathrm{GDP}=17.0\) trillion Real GDP \(=17.17\) trillion

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?

August 2017 was the sixty-fourth consecutive month that the rate of inflation as measured by the core personal consumption expenditures (PCE) price index was below the Federal Reserve's target of 2 percent. a. Briefly explain why using the consumer price index (CPI) might yield a rate of inflation different from that found using the core PCE price index. b. Explain how the choice of the price index the Federal Reserve uses to measure inflation can affect monetary policy.

According to an article on cnbc.com, the Reserve Bank of India (RBI) was expected to lower its target interest rate at its early 2017 monetary policy meeting, but instead the RBI held its target constant. RBI Governor Urjit Patel "pointed to concerns that a 'fire sale' in perishable foods was distorting what could be a worrying outlook for inflation." a. What is a "fire sale” in perishable foods, and why would it distort the outlook for inflation? b. If the RBI ignored the fire sale in perishable foods, how might it be led to set the target interest rate at the wrong level?
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