Question

What are the key differences between how we illustrate an expansionary monetary policy in the basic aggregate demand and aggregate supply model and in the dynamic aggregate demand and aggregate supply model?

Short answer

In the basic AD/AS model, expansionary monetary policy shifts the AD curve to the right, resulting in increased output and price level, signifying economic growth. On the other hand, in the DAD/DAS model, while the DAD also shifts to the right due to expansionary policy, it self-corrects in the long run with the DAS shifting to the left, resulting in a higher price level with the output returning to its natural level.

Step-by-step solution

Define Expansionary Monetary Policy

Start by defining an expansionary monetary policy. This is a type of monetary policy that involves reducing interest rates or increasing the money supply to stimulate economic activity. When the central bank of a nation employs such measures, it aims to encourage more spending within the economy.

Illustrate Expansionary Monetary Policy in Basic AD/AS Model

In a basic AD/AS model, an expansionary monetary policy will shift the AD curve to the right as lower interest rates or increased money supply encourages more investment and consumption. As this happens, the price level rises and output increases, leading to economic growth.

Illustrate Expansionary Monetary Policy in DAD/DAS Model

In the DAD/DAS Model, the effect of the expansionary monetary policy will also shift the DAD curve to the right. However, in the long run, this model anticipates inflation and adjusts wages and price levels upwards. This results in the DAS curve shifting to the left, restoring the equilibrium back to its natural level of output but with a higher price level.

Key concepts

Aggregate Demand and Supply Model

The aggregate demand and supply model, often referred to simply as the AD/AS model, is a fundamental tool used to analyze the performance of an economy. Imagine the economy as a marketplace, where aggregate demand (AD) represents the total amount of goods and services that all the consumers, businesses, and government are willing to buy at different price levels, while aggregate supply (AS) refers to the total amount of goods and services that producers are willing to sell.

In the context of monetary policy, when the central bank opts for expansionary measures—like lowering interest rates—households and businesses are incentivized to borrow and spend more. This boost in spending shifts the AD curve to the right on a graph where the horizontal axis measures the output and the vertical axis represents the price level, indicating a surge in economic activity. A rightward shift typically leads to higher output and price levels, suggesting economic expansion.

Dynamic Aggregate Demand and Supply Model

The dynamic aggregate demand and supply model (DAD/DAS model) adds an additional layer of realism to the standard AD/AS model by incorporating expectations and time into the equation. Unlike the basic AD/AS model that assumes instant adjustments, the DAD/DAS model operates with the understanding that prices and wages do not immediately adapt to policy changes.

When an expansionary monetary policy is introduced, the initial reaction is similar—a shift of the DAD curve to the right. But with time, expectations about future inflation lead workers to demand higher wages, and producers anticipate higher costs. As a result, the DAS curve eventually shifts leftward, bringing the economy back to a long-term equilibrium. This model captures the transient effects on output and the more permanent impact on the price level, offering a glimpse into the interplay between short-term economic fluctuations and long-term economic trends.

Economic Growth

Economic growth signifies an increase in the production and consumption of goods and services, leading to a rise in the standard of living over time. It is often measured by the increase in a country's real gross domestic product (GDP).

Economic growth can be spurred by various factors, including investments in capital, technological advancements, human capital development, and policy decisions. Expansionary monetary policy specifically aims to accelerate growth by making money more accessible and borrowing more affordable. This encourages spending and investment, which in turn boosts production and creates jobs. Nevertheless, it's important to balance such growth to avoid overheating the economy, which can lead to the next core concept: inflation.

Inflation

Inflation is the rate at which the general level of prices for goods and services is rising, eroding purchasing power over time. A moderate inflation rate is a sign of a growing economy, as it usually accompanies an increase in demand. However, high inflation can be detrimental, leading to a loss of consumer and business confidence, and can hurt economic growth.

Under an expansionary monetary policy, the increased supply of money in the economy can lead to inflation, especially if the growth in aggregate demand outstrips the growth in aggregate supply. In our DAD/DAS model, this is represented by the leftward shift of the DAS curve following the rightward shift of the DAD curve, resulting in higher prices. Central banks must therefore carefully manage expansionary policies to nurture economic growth while keeping inflation in check.