Graphical Analysis of Monetary Policy

Figure 26-7 on the next page illustrates the effects of a monetary expansion upon economic activity.Part (a), in the lower left, shows the money market; (b), in the ‘lower right, shows the determination of investment; and (c),in the upper right, shows the determination of aggregate demand and GDP by the multiplier mechanism. We can think of the causality as moving counterclockwise from the money market through investment to the determination of aggregate demand and GDP as a whole.

Starting at the lower left, in Figure 26-7 (a), we see the demand for and supply ‘of money that were depicted in Figures 26-5 and 26-6. For purposes of the present discussion, assume that the money surf ply schedule was initially SA and that the interest rate .. was 8 percent per year. If the Fed were concerned about a looming recession, it night increase the money supply by making open-market purchases, shifting the curve to SB’ In the case shown in Figure \26-7(a), market interest rates would thereby fall to 4 percent per year.

Additionally, asset prices tend to rise with lower interest rates. Consumption spending increases, both because lower interest rates generally increase the ‘value of wealth-as stock, bond, and housing prices tend to rise-and because consumers tend to spend more on automobiles and other big-ticket consumer durables when interest rates are lowed credit is plentiful. Moreover, as we will explore in a moment, lower interest rates tend to reduce the foreign exchange rate on the dollar, thereby increasing the level of net exports, see, then, how lower interest rates lead to increased spending in many different areas of the economy,

These consequences are evident in Figure 26-7(b), where the drop in interest rates (caused by the increase in the money supply) leads to a rise in invest from A’to B’. In this case, we should ‘construe . “investment” in the very broad sense sketched a moment a & o  it includes not only business investment but also consumer durable and residences, as well as net foreign investment in the form of net exports. Finally, Figure 26-7(c) shows the impact of changes in investment in the multiplier model. This. diagram is really Figure 24-2 turned on its side. Recall from Chapter 24 that, in the simplest multiplier model, equilibrium output is attained when desired . saving equals desired investment. In Figure 26-7(c), we have shown this relationship by drawing the saving schedule as the SS schedule this line represents the desired level, of saving (measured along the horizontal axis) as a function of GDP on the vertical axis. Equilibrium GDP is attained at that level where the investment demand from panel (b) equals the desired saving from the SS schedule.

The initial level of investment was 100, as read off at A’ in panel (b), producing a level of GDP of 3000. Meter easier money has lowered the interest rate from 8 to 4 percent, investment rises to 200 at point B’. This higher level of investment raises aggregate spending to the new equilibrium at B” in panel (c) with a new ‘equilibrium GDP of 3300.
What has occurred? The rise in the money supply from s to S8 lowered the interest rate from A to B; this caused investment to rise from A’ to B’; and this in turn, acting through the multiplier, led to a rise in GDP from AW to B”. Such is the route by which monetary policy acts through intermediate targets like the money supply and interest rates to affect its ultimate targets.

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