Chapter 18: 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 through monetary policy by decreasing the money supply or increasing interest rates. These actions result in higher borrowing costs, which reduce consumption and investment spending, ultimately leading to a decrease in aggregate demand. In the AD/AS model, this reduction in demand causes the AD curve to shift to the left, resulting in a new equilibrium with a lower price level.

Step by step solution

Understand the AD/AS model

The AD/AS model is a graphical representation of the overall economy, with the horizontal axis representing the real GDP (output) and the vertical axis representing the price level. The Aggregate Demand (AD) curve shows the quantity of goods and services demanded at different price levels, while the Aggregate Supply (AS) curve shows the quantity of goods and services supplied at different price levels. The intersection of the AD and AS curves represents the equilibrium output and price level in the economy.

Recognize the role of monetary policy in the AD/AS model

Monetary policy is a tool used by governments, usually through their central banks, to influence the money supply and interest rates in order to achieve economic objectives. In the context of the AD/AS model, monetary policy can affect the AD curve. By decreasing the money supply or increasing interest rates, the government can reduce the level of aggregate demand, which will lead to a decrease in the price level.

Decrease the money supply or increase interest rates

In order to decrease the price level, the government needs to decrease the money supply or increase interest rates using monetary policy. This can be done through tools like open-market operations (buying or selling government bonds), changes in the required reserve ratio for banks, or adjustments to the discount rate, which is the interest rate at which banks can borrow funds from the central bank.

Analyze the impact of the monetary policy changes on AD curve

When the government decreases the money supply or increases interest rates, the cost of borrowing increases, which leads to a reduction in consumption and investment spending. Consequently, the demand for goods and services in the economy decreases. In the AD/AS model, this reduction in demand causes the AD curve to shift to the left.

Identify the new equilibrium in the AD/AS model

After the AD curve has shifted to the left due to the monetary policy actions, we can identify the new equilibrium point where the new AD curve intersects with the AS curve. This new equilibrium point represents the new output and price level after the monetary policy has been implemented.

Conclusion: Decreasing the price level with monetary policy

Using the AD/AS model, we have shown that governments can use monetary policy to decrease the price level by decreasing the money supply or increasing interest rates. These actions reduce aggregate demand and shift the AD curve to the left, leading to a decrease in the equilibrium price level in the economy while also potentially affecting output.

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