TheEconomicsofMoney,Banking,andFinancialMarketsThirteenthEditionChapter21TheMonetaryPolicyandAggregateDemandCurvesCopyright?2022,2019,2016PearsonEducation,Inc.AllRightsReservedPreviewThischapterdevelopsanexplanationforwhymonetarypolicymakersputupwardpressureoninterestrateswheninflationincreases.Thisrelationshipisthenusedtodevelopthemonetarypolicycurve.ThemonetarypolicycurveisthenusedinconjunctionwiththeI

Sscheduletoderiveanaggregatedemandcurve,whichshallbeusedinthediscussionsthatfollow.LearningObjectives21.1Recognizetheimpactofchangesinthenominalfederalfundsrateonshort-termrealinterestrates.21.2Defineandillustratethemonetarypolicy(M

P)curveandexplainshiftsintheM

Pcurve.21.3Explainwhytheaggregatedemand(A

D)curveslopesdownwardandexplainshiftsintheA

Dcurve.TheFederalReserveandMonetaryPolicyTheFedoftheUnitedStatesconductsmonetarypolicybysettingthefederalfundsrate—theinterestrateatwhichbankslendtoeachother.WhentheFederalReservelowersthefederalfundsrate,realinterestratesfall.WhentheFederalReserveraisesthefederalfundsrate,realinterestratesrise.TheMonetaryPolicyCurveThemonetarypolicy(M

P)curve

showshowmonetarypolicy,measuredbytherealinterestrate,reactstotheinflationrate,TheM

Pcurveisupwardsloping.Realinterestratesrisewhentheinflationraterises.Figure1TheMonetaryPolicyCurveTheTaylorPrinciple:WhytheMonetaryPolicyCurveHasanUpwardSlopeThekeyreasonforanupwardslopingM

Pcurveisthatcentralbanksseektokeepinflationstable.Taylorprinciple:Tostabilizeinflation,centralbanksmustraisenominalinterestratesbymorethananyriseinexpectedinflation,sothatrriseswhenrises.Schematically,ifacentralbankallowsrtofallwhenrises,thenApplication:MovementsAlongtheM

PCurve:TheRiseintheFederalFundsRateTarget,2004–2006and2015–2019AstheFederalReservereactedtoinflationarypressuresduringtheperiod2004-2006andagainduring2015-2019,itsmonetarypolicyactionswereclearlymovementsalongtheM

Pcurve,say,frompointAtoBtoCinFigure1.TheFedwasfollowingtheTaylorprinciple,reactingtohigherinflationbyraisingtherealinterestrate.ShiftsintheM

PCurveTwotypesofmonetarypolicyactionsthataffectinterestrates:Automatic(Taylorprinciple)changesasreflectedbymovementsalongtheM

Pcurve(2004–2006)AutonomouschangesthatshifttheM

PcurveAutonomoustighteningofmonetarypolicythatshiftstheM

Pcurveupward(inordertoreduceinflation)Autonomouseasingofmonetarypolicy

thatshiftstheM

Pcurvedownward(inordertostimulatetheeconomyastheFedwasdoingintheperiodleadinguptotheglobalfinancialcrisis)Figure2ShiftsintheMonetaryPolicyCurveApplication:ShiftintheM

PCurve:AutonomousMonetaryEasingDuringtheGlobalFinancialandCoronavirusCrisesTheFedpursuedanautonomousmonetarypolicyeasingbecausethenegativeshocktotheeconomycausedbythedisruptiontofinancialmarketsandthecoronaviruspandemicindicatedthattheeconomywaslikelytoweakeninthenearfuture,andtheinflationratewouldthenfall.Indeed,thisisexactlywhatcametopass,withtheeconomygoingintoarecessionaftertheonsetoftheglobalfinancialandcoronaviruscrises.TheFed’sactionsinbothcasesthusshiftedthemonetarypolicycurvedown,fromM

P1toM

P3,asshowninFigure2.Figure3TheFederalFundsRateandInflationRate,2003–2020Source:FederalReserveBankofSt.LouisF

R

E

Ddatabase:http:///fred2/series/CPIAUCSL

;http:///fred2/series/FEDFUNDS

.TheAggregateDemandCurveTheaggregatedemand

curverepresentstherelationshipbetweentheinflationrateandaggregatedemandwhenthegoodsmarketisinequilibrium.Theaggregatedemandcurveiscentraltoaggregatedemandandsupplyanalysis,whichallowsustoexplainshort-runfluctuationsinbothaggregateoutputandinflation.DerivingtheAggregateDemandCurveGraphicallyTheA

Dcurveisderivedfrom:TheM

PcurveTheI

ScurveTheA

Dcurvehasadownwardslope:Asinflationrises,therealinterestraterises,sothatspendingandequilibriumaggregateoutputfall.Figure4DerivingtheA

DCurveF

Y

I:DerivingtheA

DCurveAlgebraicallySimilarly,wecanderiveamoregeneralversionoftheA

DcurvebyusingthealgebraicversionoftheI

ScurvegivenbyEquation12inChapter20:

WethensubstituteforrusingthealgebraicM

PcurvegiveninEquation1,r=r+l

p,togetthemoregeneralequationoftheA

Dcurve:FactorsThatShifttheAggregateDemandCurve(1of2)ShiftsintheI

ScurveAutonomousconsumptionexpenditureAutonomousinvestmentspendingGovernmentpurchasesTaxesAutonomousnetexportsFinancialfrictionsAnyfactorthatshiftstheIScurveshiftstheaggregatedemandcurveinthesamedirection.Figure5ShiftintheA

DCurveFromShiftsintheI

SCurveFactorsThatShifttheAggregateDemandCurve(2of2)ShiftsintheM

PcurveAnautonomoustighteningofmonetarypolicy,thatisariseinrealinterestrateatanygiveninflationrate,shiftstheaggregatedemandcurvetotheleftSimilarly,anautonomouseasingofmonetarypolicyshiftstheaggregatedemandcurvetotherightFigure6ShiftintheA

DCurveFromAutonomousMonetaryPolicyTighteningCopyrigh