Chapter 32: Problem 9

Show, using the AD/AS model, how governments can use monetary policy to decrease the price level.

Short Answer

Expert verified

Using the AD/AS model, governments can decrease the price level by implementing contractionary monetary policy, such as reducing the money supply or raising interest rates. This discourages borrowing and spending, reducing the overall aggregate demand in the economy. As a result, the aggregate demand curve shifts leftward, leading to a new equilibrium with lower real output and a decreased price level. However, this policy may also result in higher unemployment due to reduced real output.

Step by step solution

Understand the AD/AS model

The Aggregate Demand/Aggregate Supply (AD/AS) model is an economic model that demonstrates the relationship between an economy's total demand (AD) for goods and services and the total supply of them (AS). It can be represented graphically by the intersection of the AD and AS curves. The equilibrium in this model is the point at which the quantity of goods and services demanded equals the quantity supplied, determining the equilibrium price level and real output.

Understand Monetary Policy

Monetary policy refers to the actions taken by central banks (such as the Federal Reserve in the United States) to manage a nation's money supply and interest rates with the aim of achieving macroeconomic objectives like controlling inflation, maintaining full employment, and promoting economic growth. Central banks can use various tools, such as open-market operations, reserve requirements, or discount rates, to influence the money supply and interest rates.

Establish the relationship between Monetary Policy and Price Levels

The relationship between monetary policy and price levels can be explained through the AD/AS model. Expansionary monetary policy, which involves increasing the money supply or lowering interest rates, shifts the AD curve to the right, increasing the price level. On the other hand, contractionary monetary policy, which involves decreasing the money supply or raising interest rates, shifts the AD curve to the left, decreasing the price level. Now, let's demonstrate how governments can use monetary policy to decrease the price level:

Initial equilibrium

First, consider an economy in its initial equilibrium, with the aggregate demand curve (AD) intersecting the aggregate supply curve (AS) at point E₀. This equilibrium represents the initial levels of both real output (Y₀) and the price level (P₀).

Implement Contractionary Monetary Policy

To decrease the price level, the government or central bank can implement contractionary monetary policy. This may involve decreasing the money supply or raising interest rates. Raising interest rates discourages borrowing and encourages saving, leading to a reduction in consumer spending and business investment. Consequently, this reduces the overall aggregate demand in the economy.

Shift the Aggregate Demand Curve

The contractionary monetary policy will shift the aggregate demand curve to the left, from AD₀ to AD₁. As aggregate demand decreases, the equilibrium point moves from E₀ to E₁. The new equilibrium (E₁) reflects a lower level of real output (Y₁) and a decreased price level (P₁).

Conclude the Result

Through the implementation of contractionary monetary policy, the government or central bank can decrease the price level in the economy. In the AD/AS model, this is demonstrated as a leftward shift of the AD curve, resulting in a new equilibrium with a lower price level. However, it is important to note that this policy may also lead to a decrease in real output and potentially higher unemployment.

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