AP_Krugman_Textbook

310 section 6 Inflation, Unemployment, and Stabilization Policies

Expansionary and Contractionary Monetary Policy

Previously we said that monetary policy shifts the aggregate demand curve. We can

now explain how that works: through the effect of monetary policy on the interest rate.

Suppose that the Federal Reserve expands the money supply. As we’ve seen, this

leads to a lower interest rate. A lower interest rate, in turn, will lead to more invest-

ment spending, which will lead to higher real GDP, which will lead to higher con-

sumer spending, and so on through the multiplier process. So the total quantity of

goods and services demanded at any given aggregate price level rises when the quan-

tity of money increases, and the ADcurve shifts to the right. Monetary policy that

shifts the ADcurve to the right, as illustrated in panel (a) of Figure 31.3, is known as

expansionary monetary policy.

Suppose, alternatively, that the Federal Reserve contracts the money supply. This leads

to a higher interest rate. The higher interest rate leads to lower investment spending,

which leads to lower real GDP, which leads to lower consumer spending, and so on. So

the total quantity of goods and services demanded falls when the money supply is re-

duced, and the ADcurve shifts to the left. Monetary policy that shifts the ADcurve to the

left, as illustrated in panel (b) of Figure 31.3, is called contractionary monetary policy.

Module 66Oligopoly in Practice

We have learned that policy makers try to fight recessions. They also try to ensure price

stability: low (though usually not zero) inflation. Actual monetary policy reflects a com-

bination of these goals.

In general, the Federal Reserve and other central banks tend to engage in expansion-

ary monetary policy when actual real GDP is below potential output. Panel (a) of Fig-

ure 31.4 shows the U.S. output gap, which we defined as the percentage difference

between actual real GDP and potential output, versus the federal funds rate since 1985.

(Recall that the output gap is positive when actual real GDP exceeds potential output.)

Real GDP

Aggregate

price

level

(a) Expansionary Monetary Policy

AD 1 AD 2 AD 3 AD 1

Real GDP

Aggregate

price

level

(b) Contractionary Monetary Policy

figure 31.3 Monetary Policy and Aggregate Demand

Anexpansionary monetary policy,shown in panel (a), shifts the

aggregate demand curve to the right from AD 1 toAD 2. A con-

tractionary monetary policy,shown in panel (b), shifts the ag-

gregate demand curve to the left, from AD 1 toAD 3.

Expansionary monetary policyis
monetary policy that increases aggregate
demand.

Contractionary monetary policyis
monetary policy that reduces aggregate
demand.