Chapter 19: Problem 9

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

Short Answer

Expert verified

In the AD/AS model, contractionary monetary policy is used by the government to decrease the price level. The central bank decreases the money supply and raises interest rates, making borrowing more expensive and reducing demand for goods and services. This leads to a leftward shift in the AD curve, resulting in a new equilibrium with a lower price level.

Step by step solution

Understand the AD/AS model

The AD/AS model is an economic representation of the interaction between aggregate demand (AD) and aggregate supply (AS) in an economy. Aggregate demand represents the total demand for all goods and services, while aggregate supply represents the total supply of goods and services. The interaction between these two forces determines the equilibrium price level and output in an economy.

Understanding monetary policy

Monetary policy is the actions taken by a country's central bank to control the money supply and interest rates in the economy. Central banks use monetary policy tools like open market operations (buying or selling government securities), setting the discount rate, and reserve requirements to influence interest rates. A key interest rate the central bank can control is the short term interest rate.

Expansionary and contractionary monetary policy

There are two types of monetary policy: expansionary and contractionary. Expansionary monetary policy aims to increase the money supply and lower interest rates to stimulate economic activity. On the other hand, contractionary monetary policy aims to decrease the money supply and raise interest rates, intending to slow down economic activity and control inflation. In this exercise, we need to show how the government can use monetary policy to decrease the price level, which indicates a contractionary monetary policy.

How contractionary monetary policy affects AD and AS

When a central bank adopts contractionary monetary policy, it decreases the money supply and raises interest rates in the economy. Higher interest rates make borrowing more expensive for consumers and businesses, which leads to lower demand for goods and services. Lower borrowing also means less investment in businesses, reducing aggregate demand (AD) in the economy. As AD decreases, it shifts the AD curve in the AD/AS model to the left. As AD shifts leftward, there will be a new intersection point between the AD and AS curves, indicating a new equilibrium.

Decreasing the price level

At the new equilibrium point, the demand for goods and services is lower, which puts downward pressure on the price level. As a result, the price level decreases due to the contractionary monetary policy. In conclusion, by employing contractionary monetary policy and increasing interest rates, the government can effectively decrease the aggregate demand in the economy and, in turn, decrease the price level, as shown in the AD/AS model.