MacroeconomicsI_working_version (1)

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Chapter 13
(a) Monetary Tightening
(b) Money-Demand Shift
i
MS‘
MS
i
MS
E‘
i 1
E‘’
i 1
E
i 0
M*‘ M* M*
MD
i 0
E
MD’
MD
M
M
Figure 13.3 Interest rates affected by changes in monetary policy or prices. The panel (a) shows the
impact of reduced money supply on interest rates. The impact of increased demand for money is described in
the panel (b).
There are two basic determinants of money markets: (1) the public’s desire to hold money
(represented by the demand for money MD curve) and (2) the central bank’s monetary
policy (which is shown in Figure 13.2 as a fixed money supply or a vertical MS curve at
point M*). They jointly determine the market interest rate, i. A restrictive monetary policy
(tight money) moves the MS curve to the left, which implies higher interest rates. A rise in
overall price level or in national output moves the MD curve rightwards and increases
interest rates.
13.3. Monetary Policy in the AS-AD Framework
In the previous text, we examined, how an increase in the money supply rises aggregate
spending and thus aggregate demand. Accordingly, altering money supply influences
macroeconomic equilibrium in terms of aggregate demand and supply model.
As shown in Figure 13.4 the initial equilibrium corresponds to an economy in the situation
with unemployed resources, output gap and relatively flat AS curve. The monetary
expansion shifts the AD curve rightwards to AD’. The overall equilibrium also moves from
E to E’. In this case the monetary expansion leads to an increase in prices and rise in real
output.
We can describe the process as follows:
M up → i down → I,C, X up → AD up → GDP up and P up