Chapter 21: The Monetary Policy and Aggregate Demand Curves Flashcards
The Federal Reserve and Monetary Policy
The Fed conducts monetary policy by setting the federal funds rate (interest rate at which banks lend to each other)
1) Fed lowers federal funds rate => real interest rates fall
2) Fed raises federal funds rate => real interest rates rise
The Monetary Policy Curve
shows how monetary policy, measured by the real interest rate, reacts to the inflation rate, pi: see slide for formula
-curve is upward sloping bc real interest rates rise when the inflation rate rises
The Taylor Principle
To stabilize inflation, central banks must raise nominal interest rates by more than any rise in expected inflation, so that r rises when inflation rises
Two types of monetary policy actions that affect interest rates
1) Automatic (Taylor principle) changes as reflected by movements along the MP curve
2) Autonomous changes that shift the MP curve
- Tightening of monetary policy shifts curve upward
- Easing of monetary policy shifts curve downward
The Aggregate Demand Curve
- Relationship between the inflation rate and aggregate demand when the goods market is in equilibrium
- Allows us to explain short-run fluctuations in both aggregate output and inflation
- Downward sloping bc as inflation rises, the real interest rate rises, so spending and equilibrium aggregate output fall see graphs in slides
Factors that shift the aggregate demand curve
1) Autonomous monetary policy increases = shift left
2) Government purchases increase = shift right
3) Taxes increase = shift left
4) Autonomous net exports = shift right
5) Autonomous consumption expenditure = shift right
6) Autonomous investment = shift right
7) Financial frictions = shift left
Factors that shift the aggregate demand curve
1) Shifts in the IS curve
- Any factor that shifts the IS curve shifts the aggregate demand curve in the same direction
2) Shifts in the MP curve
- Tightening of monetary policy ( ^ RIR) = shift left
- Easing of monetary policy = shift right
