Relationship between monetary policy and aggregate demand formula

AD–AS model - Wikipedia

relationship between monetary policy and aggregate demand formula

This creates a relationship between monetary policy and aggregate demand. This brings us to the aggregate demand curve. It specifies the amounts of goods . 1. The Influence of. Monetary and Fiscal. Policy on Aggregate. Demand Thus the quantity of money supplied does not . The formula for the multiplier is. tradeMoff between inflation and unemployment in the short run. Economic In section 4, we fill in the link from the governmentGs output reaction function to the the model in three equations: the Expectations Augmented Phillips Curve.

Through making appropriate changes in monetary policy the Government can influence the level of economic activity. Monetary policy may also be expansionary or contractionary depending on the prevailing economic situation.

Chapter Monetary Policy

IS-LM model can be used to show the effect of expansionary and tight monetary policies. A change in money supply causes a shift in the LM curve; expansion in money supply shifts it to the right and decrease in money supply shifts it to the left.

Suppose the economy is in grip of recession, the Government through its Central Bank adopts the expansionary monetary policy to lift the economy out of recession. Thus, it takes measures to increase the money supply in the economy.

The increase in money supply, state of liquidity preference or demand for money remaining unchanged, will lead to the fall in rate of interest. At a lower interest there will be more investment by businessmen.

More investment will cause aggregate demand and income to rise. This implies that with expansion in money supply LM curve will shift to the right as is shown in Fig. As a result, the economy will move from equilibrium point E to D and with this the rate of interest will fall from r1 to r2 and national income will increase from Y1 to Y2.

Thus, IS-LM model shows that expansion in money supply lowers interest rate and raises income.

relationship between monetary policy and aggregate demand formula

We have also indicated what is called monetary transmission mechanism, that is, how IS-LM curve model shows the expansion in money supply leads to the increase in aggregate demand for goods and services. We have thus seen that increase in money supply lowers the rate of interest which then stimulates more investment demand. Increase in investment demand through multiplier process leads to a greater increase in aggregate demand and national income.

If the economy suffers from inflation, the Government will like to check it. Then its Central Bank should adopt tight or contractionary monetary policy. To control inflation the Central Bank of a country can reduce money supply through open market operations by selling bonds or government securities in the open market and in return gets currency funds from those who buy the bonds.

In this way liquidity in the banking system can be reduced. To reduce money supply for fighting inflation the Central Bank can also raise cash reserve ratio of the banks.

relationship between monetary policy and aggregate demand formula

The higher cash reserve ratio implies that the banks have to keep more cash reserve with the Central Bank. As a result, the cash reserves with the banks fall which force them to contract credit.

Thus, as we can see from the diagram, the aggregate demand curve shifts rightward in case of a monetary expansion.

AD–AS model

Aggregate supply curve[ edit ] Main article: Aggregate supply The aggregate supply curve may reflect either labor market disequilibrium or labor market equilibrium. In either case, it shows how much output is supplied by firms at various potential price levels. The aggregate supply curve AS curve describes for each given price level, the quantity of output the firms plan to supply. The Keynesian aggregate supply curve shows that the AS curve is significantly horizontal implying that the firm will supply whatever amount of goods is demanded at a particular price level during an economic depression.

The idea behind that is because there is unemployment, firms can readily obtain as much labour as they want at that current wage and production can increase without any additional costs e.

Firms' average costs of production therefore are assumed not to change as their output level changes.

relationship between monetary policy and aggregate demand formula

This provides a rationale for Keynesians' support for government intervention. The total output of an economy can decline without the price level declining; this fact, in conjunction with the Keynesian belief of wages being inflexible downwards, clarifies the need for government stimulus. Since wages cannot readily adjust low enough for aggregate supply to shift outward and improve total output, the government must intervene to accomplish this result.

However, the Keynesian aggregate supply curve also contains a normally upward-sloping region where aggregate supply responds accordingly to changes in price level. The upward slope is due to the law of diminishing returns as firms increase output, which states that it will become marginally more expensive to accomplish the same level of improvement in productive capacity as firms grow.

It is also due to the scarcity of natural resources, the rarity of which causes increased production to also become more expensive. The vertical section of the Keynesian curve corresponds to the physical limit of the economy, where it is impossible to increase output.

The classical aggregate supply curve comprises a short-run aggregate supply curve and a vertical long-run aggregate supply curve.

relationship between monetary policy and aggregate demand formula

The short-run curve visualizes the total planned output of goods and services in the economy at a particular price level. The "short-run" is defined as the period during which only final good prices adjust and factor, or input, costs do not.

relationship between monetary policy and aggregate demand formula

The "long-run" is the period after which factor prices are able to adjust accordingly. The short-run aggregate supply curve has an upward slope for the same reasons the Keynesian AS curve has one: The long-run aggregate supply curve is vertical because factor prices will have adjusted. Factor prices increase if producing at a point beyond full employment output, shifting the short-run aggregate supply inwards so equilibrium occurs somewhere along full employment output.

Monetarists have argued that demand-side expansionary policies favoured by Keynesian economists are solely inflationary. As the aggregate demand curve is shifted outward, the general price level increases. This increased price level causes households, or the owners of the factors of production to demand higher prices for their goods and services.

The consequence of this is increased production costs for firms, causing short-run aggregate demand to shift back inwards. The theoretical ultimate result is inflation.

Keynesian economics - Aggregate demand and aggregate supply - Macroeconomics - Khan Academy

In the short run wages and other resource prices are sticky and slow to adjust to new price levels.