Question

list and briefly explain the steps in how monetary policy affects real gdp in the as/ad model using as your example the case when the fed eases monetary policy to fight a recession.

Answer 1

Expansionary monetary policy combats recession by lowering interest rates to stimulate investment and consumption, shifting aggregate demand right, thereby increasing output toward potential GDP.

Step-by-step explanation:

When the Federal Reserve eases monetary policy to combat a recession, it affects real GDP through a series of steps, particularly in a traditional Keynesian AS/AD model. Initially, the economy is in a recession, with high unemployment and output below potential GDP. For example, the starting equilibrium point Eo might be at an output level of 600.

Here are the steps following the implementation of an expansionary monetary policy:

1. The Federal Reserve enacts expansionary monetary policy, often by lowering interest rates, which makes borrowing cheaper.
2. Lower interest rates encourage businesses to invest and consumers to spend more, which increases aggregate demand.
3. The increased aggregate demand causes the AD curve to shift to the right from AD to AD₁.
4. This shift leads to a new equilibrium at E₁, with a higher output level, helping to move the economy back towards potential GDP, which in our example is indicated as a level of 700.

In the short run, this will also lead to a rise in the price level, but with the goal of reducing unemployment and increasing output. In contrast, in a neoclassical view, such monetary interventions only affect the price level and not the long-run level of output or unemployment rate.