Question

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

Short answer

In both models, contractionary monetary policy is shown as a decrease in aggregate demand - a shift to the left of aggregate demand curve. However, in the dynamic model, this policy also accounts for changes in inflation expectations leading to a shift in short-run aggregate supply or a movement along it.

Step-by-step solution

Understanding the Models

The Basic Aggregate Demand and Supply Model defines equilibrium in the economy as the point where aggregate demand equals aggregate supply. On the other hand, The Dynamic Aggregate Demand and Supply Model, taking into account inflation and growth, depicts short-run equilibrium as the interaction of aggregate demand, short-run aggregate supply, and long-run aggregate supply.

Contractionary Policy in Basic AD-AS model

In the basic AD-AS model, a contractionary monetary policy is shown as a shift to the left in the aggregate demand curve. This is because the policy reduces the money in circulation, elevating interest rates and reducing spending.

Contractionary Policy in Dynamic AD-AS model

In the dynamic AD-AS model, the same policy manifests as a movement along the short-run aggregate supply curve due to change in inflation expectations or a shift to the left of short-run aggregate supply curve when policy reduces money output. This reduces spending but also shifts lenders' and consumers' expectations.

Comparison of the models

While both models illustrate a decrease in aggregate demand due to contractionary monetary policy, the dynamic model additionally takes into account the change in inflation expectations. The dynamic model sees a shift in short-run aggregate supply and a movement along it due to changes in policy and economic actors' reactions, respectively.

Key concepts

Aggregate Demand and Supply Model

The Aggregate Demand and Supply (AD-AS) model is a fundamental economic tool used to illustrate the interaction between the total goods and services demanded and supplied in an economy. The basic framework consists of two main curves: aggregate demand (AD) and aggregate supply (AS).
The aggregate demand curve represents the total quantity of goods and services demanded across different price levels. It slopes downwards because higher prices typically lead to lower quantity demanded due to reduced purchasing power. The aggregate supply curve can be thought of in two facets: short-run aggregate supply (SRAS) and long-run aggregate supply (LRAS).
The short-run aggregate supply curve is upward sloping, indicating that as prices increase, the quantity supplied increases due to temporary profit maximization.

• In the short run, firms can increase production by utilizing existing resources more intensively.
• The long-run aggregate supply curve is vertical, reflecting the economy’s maximum sustainable output when all resources are fully utilized.

This model helps in understanding economic fluctuations and is a primary framework for various economic policies, including monetary policy.

Contractionary Monetary Policy

Contractionary monetary policy is a type of economic policy used to combat inflation by controlling the amount of money circulating in the economy. Central banks implement these policies primarily through interest rate adjustments and selling government securities.
This policy aims to reduce inflation and stabilize the currency value by cooling down an overheated economy. Here's how it works:

• The central bank increases interest rates, making borrowing more expensive, which reduces consumer spending and business investments.
• Higher interest rates also attract foreign capital, increasing the demand for domestic currency and strengthening its value.

In the basic AD-AS model, contractionary monetary policy is depicted as a leftward shift in the aggregate demand curve.
This shift illustrates a reduction in demand due to decreased spending and investment.
This way, the economy can move towards equilibrium with lower inflation rates but possibly at the cost of reduced economic growth and increased unemployment in the short term.

Dynamic Aggregate Demand and Supply Model

The Dynamic Aggregate Demand and Supply model builds upon the basic AD-AS model by incorporating additional complexities like inflation expectations and economic growth over time. This model considers not just the current interactions but also how they change over time.
In this dynamic model:

• Inflation expectations play a critical role as they influence both demand and supply sides of the economy.
• Economic agents, that is, consumers and businesses, adjust their expectations and actions based on anticipated inflation.

This model reflects the realities of a real-world economy more precisely where future expectations significantly affect present economic decisions.
When a contractionary monetary policy is applied in a dynamic AD-AS framework, it doesn't only cause the demand to shift but also affects inflation expectations. This could lead to a movement along the short-run aggregate supply curve or even shift the curve itself if the policy changes expectations significantly.
This dynamic nature showcases how continuous adjustments can affect short-run and long-run equilibria differently than in the static model.

Inflation Expectations

Inflation expectations refer to what consumers, firms, and financial decision-makers anticipate will happen to prices in the future. These expectations can influence present economic behavior drastically.
If people expect prices to rise, they might spend more now rather than later, thereby increasing current demand. Similarly, firms might raise prices in anticipation of higher costs in the future.

• These expectations magnify the impacts of monetary policy, as behavior adjusts in line with expected price changes.
• They can also make inflation a self-fulfilling prophecy if widely believed.

In the context of the dynamic AD-AS model, inflation expectations introduce a layer of complexity. Changes in these expectations can shift the short-run aggregate supply curve. When inflation expectations rise, workers and suppliers tend to push for higher wages and prices respectively, which shifts the SRAS to the left.
Therefore, managing these expectations is crucial for central banks when implementing monetary policies to ensure that their intended outcomes are achieved without unexpected inflation surges.