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Economics: Monetary Responses to Economy Changes


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About this Lesson

  • Type: Video Tutorial
  • Length: 12:20
  • Media: Video/mp4
  • Use: Watch Online & Download
  • Access Period: Unrestricted
  • Download: MP4 (iPod compatible)
  • Size: 131 MB
  • Posted: 03/29/2010

This lesson is part of the following series:

Economics: Full Course (269 lessons, $198.00)
Economics: Monetary and Fiscal Policy (17 lessons, $27.72)
Economics: Monetary Policy: The Mainstream (5 lessons, $8.91)

This economics video lesson will teach you about monetary responses to changes in the economy. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.

Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.

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We're going to use our model of the macroeconomy to show how monetary policy can be an effective response to other changes in the economic environment. What we're going to do is shift each of the three curves in our picture and show how, in each case, monetary policy can either shorten a recession or prevent inflation. Let's look at what happens, first of all, if the aggregate demand curve shifts.
Suppose the aggregate demand curve were to shift inward representing a reduction in aggregate demand and setting up a recession. If aggregate demand goes from AD[0] to AD[1], the economy is going to tend to adjust to a position with lower prices and less output. This shift in aggregate demand would occur if, for instance, the government reduced its spending or if consumers lost confidence in the economy and started saving instead of spending, or if businesses decided that, in fact, the outlook was not bright and, therefore, wanted to do less business spending or foreigners started buying their goods elsewhere. If there's a reduction in aggregate demand, we get lower prices and less output. What can monetary policy do in this case?
First, ask the question, "What would happen in the absence of any policy response?" Well, what would happen because we're at an output level that's below full employment, what happens is that the price level begins to fall because of slack in the labor market and resource markets, those prices begin to fall, and competitive businesses pass those lower costs onto their consumers in the form of lower product prices. Therefore, the short-run aggregate supply curve shifts from its original level downwards until eventually it reaches SRAS, the end result of the adjustment process, at a much lower price level P and full employment. So the first thing to keep in mind in all of these stories is that if the economy is left to its own devices, it will eventually adjust back to full employment. Now, you know that prices tend to fall less easily than they rise. Wages are sticky downwards. In that case it's more likely that a recession will persist because it takes a while for the slack in the labor market to actually translate into lower wages, therefore, the economy could hang out at this point for some time in a recession and only after a fairly long adjustment period does full employment get re-established. The classical economists said to John Maynard Keynes, "Hey, leave the economy alone." In the long run it adjusts back to full employment. Keynes, thinking about sticky wages said, Yeah, but in the long run we are all dead. So what can we do rather than sit here and endure a long recession?
Well, monetary policy could be used. The Fed could reduce the reserve requirement, buy government securities or lower the discount rate and make more loans to banks, and in so doing, shift the aggregate demand curve back out to its original position. That then, prevents the adjustment process of prices, and takes the economy right back to where it was. So if aggregate demand is reduced because of changes in autonomist spending, then the Federal Reserve can respond with a countervailing monetary policy. Expansionary monetary policy is a response to a contraction in demand and the result is the economy goes right back where it was. As demand shifts the economy in, the Fed can shift it back out and leave us right where we were without a long painful recession. In theory, that's how expansionary monetary policy responds to a contraction in demand.
Let's look at another case in which the Fed can respond to a shift in one of the policy curves. Suppose that we have a supply shock in our economy and this supply shock shifts the short-run aggregate supply curve upwards. This supply shock might be an increase in the price of oil, perhaps due to a war in the Middle East. If that happens, then the higher price of oil gets passed on by businesses to their customers in the form of higher product prices. The short-run aggregate supply curve shifts inward and takes the economy to a new point, here, with a higher price level and lower output.
Now, this is kind of interesting because it's in violation of the usual conventional wisdom that a reduction in output is associated with lower prices. In the example we just saw with an inward shift in the demand curve, we have lower prices in response to less output. So at least we didn't have the problem of inflation and recession simultaneously. When the supply curve shifts upwards because of a supply shock like higher oil prices, we get higher prices and lower output, simultaneous inflation and recession. This is called stagflation, the coincidence of rising prices and declining output. We've got both problems at once.
Well, how can this problem be solved? First of all, keep in mind that if the Fed does nothing at all, then the short-run aggregate supply curve will begin to shift back to its original position. The shift back to the original position occurs because after the supply shock, the economy is dragged down to an output level that's below full employment. This means prices are going to tend to fall and as prices fall, the short-run aggregate supply curve shifts outwards and takes the economy back down the aggregate demand curve to its original position. So, if we do nothing, the economy will adjust, but it may take forever, and may have to endure a long period of unemployment. On the other hand, the Fed could take swift action to prevent this recession by using expansionary monetary policy. The expansionary monetary policy would shift the aggregate demand curve out to this new position and establish an equilibrium back at full employment, but this time with a higher price level.
So this new higher price level, we'll call this P[2], is the result of the Feds increasing the money supply. When the Fed increases the money supply, interest rates fall and businesses begin to increase investment spending. So with the supply shock, businesses cut back their activity of producing and as the prices rose, consumers and businesses found themselves spending less. When the Fed increases the money supply by lowering reserve requirements, buying government securities and so on, the interest rate falls and business investment spending is stimulated. So the economy returns to full employment only now we've got a higher price level and that's the cost here. You can't have the best of both worlds here. You can't have lower prices and higher output because a tradeoff is created by the supply shock. We can either increase the money supply and have higher prices and get back to full employment or we can leave the money supply unchanged and endure a recession and let the economy gradually adjust back to full employment. If the Fed wanted to take prices back to their original level after the supply shock, the Fed would have to decrease aggregate demand and deepen the recession.
Now this has certainly happened in certain periods. We've had deep recessions, for example, in the early 1980's when the Federal Reserve was aggressively fighting inflation. But see here, the inward shift of the aggregate supply curve following the supply shock has created a tradeoff in which the Fed can either restore full employment at a higher price level or lower the price level by shifting in the red curve at the cost of an even deeper recession. So this is how monetary policy works when there's a supply shock in the economy.
Finally, let's consider a case in which the green curve itself moves. What happens if the economy enters a period of very high productivity? Well, let's look. Suppose the supply curve shifts outwards. The long-run aggregate supply curve shifts outwards, representing an increase in the productive capacity of the economy. We'll call this new curve LRAS[1]. So the economy has increased its productive capacity through, for example, an improvement in technology or immigration or an increase in the capital stock. Remember, any time you shift over the green curve, you've got to drag the blue curve along with it. The short-run supply curve always moves right along with the long-run aggregate supply curve because these two curves are attached. Now what's going to happen in the short run is we go to the intersection of our aggregate demand curve and our short-run supply curve. So what happens here is the technological progress and the shift in the long-run aggregate supply curve gives us a lower price level, P[1], and an increase in output from the original full employment level, YF[0], to a new output level, Y[1]. What will happen if we leave this economy alone? Well, what's going to happen is prices are gradually going to fall until we have a new short-run aggregate supply curve, SRAS with a higher level of output at the new full employment level, YF[1] and lower prices, down here, at a level that we can call P. So the economy here is headed in a good direction. Look at this. We have prices falling and output increasing. That's the great thing that can happen when the supply curve shifts in a favorable direction. You get prices decreasing, that is deflation, but you also get output increasing. That's a good result. We call this good deflation, as opposed to the first case where prices were falling because the economy had insufficient demand. We call that bad deflation.
Well, what can monetary policy do here in this case? Well, monetary policy could hasten our arrival of the new output level. If the Federal Reserve decided that it wanted to move us to this new output level quickly, it could shift out the aggregate demand curve and prevent this adjustment process. What it would do is shift out the aggregate demand curve so that it intersected the short-run aggregate supply curve right on top of our new full employment line. That is, the Fed could keep the price level constant and immediately jump to a larger level of output. If the Fed wanted to keep prices constant and stimulate the economy, it could move us to this new aggregate demand curve, AD[1], by expanding the money supply. Expansionary monetary policy immediately moves us to our long-run output level without any change in the prices at all. So that's what can happen. When the economy grows, the Fed will often accommodate the growth in the economy by providing extra money supply to meet the increased money demand.
So this is how monetary policy works. In every case the effectiveness of monetary policy and the need for monetary policy depends on how quickly prices adjust. If prices adjust very, very quickly, then monetary policy really has no affect except for on the price level. However, if the economy is slow to adjust as is often the case whenever we are below full employment, then monetary policy well used can cause a recession to be shorter and not as deep as it might otherwise be.
Monetary policy is probably most effective in situations where there is a sudden reduction of demand. The economy can be stimulated by an increase in the money supply so if people stop spending money and the economy is slipping into recession, the first case was showed, a shift inward in the aggregate demand curve. Then monetary policy can compensate for the reduction in demand by stimulating spending through lower interest rates.
Monetary and Fiscal Policy
Monetary Policy: The Mainstream
Monetary Responses to Changes in the Economy Page [3 of 3]

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