15.4 Monetary Policy, Real GDP, and the Price Level

What happens when the Fed shifts the money supply curve rightward from S_m1 to S_m2?

The interest rate falls from 10% to 8%, investment rises from $15B to $20B, aggregate demand shifts right, and real GDP increases from $880B to $900B (full employment).

What is the ultimate objective of expansionary monetary policy?

An increase in real GDP from Q_1 to Q_f.

What happens when the Fed shifts the money supply curve leftward from S_m3 to $162.5B?

Interest rate rises from 6% to 7%, investment falls from $25B to $22.5B, aggregate demand shifts left by $10B, returning GDP to full employment and eliminating the inflationary gap

What evidences a successful restrictive monetary policy?

A shift in the money supply curve from S_m3 to halfway toward S_m2, investment decreases from $25B to $22.5B, and aggregate demand declines from AD_3 to AD_4.

How could the Fed increase the money supply from S_m1 to S_m2?

By purchasing bonds as part of quantitative easing (QE).

If the multiplier is 4, what happens when the money supply increases from $125B to $150B?

Aggregate demand shifts rightward by $20B.

Why are money supply curves vertical in the market for money diagram?

Because the Fed sets the money supply independently of the interest rate

What is the equilibrium interest rate when the money supply is $125B, $150B, and $175B?

$125B → 10%; $150B → 8%; $175B → 6%.

Why is the real interest rate critical in these diagrams?

Because real (not nominal) interest rates determine investment decisions.

What is the relationship between real interest rates and investment spending?

Inverse relationship — as real interest rates fall, investment spending rises; as rates rise, investment falls.

At a 10% real interest rate, how much investment spending occurs?

$15B

At an 8% real interest rate, how much investment spending occurs?

$20B

At a 6% real interest rate, how much investment spending occurs?

$25B

Why do changes in interest rates strongly affect investment spending?

Because capital purchases (equipment, factories, warehouses) are very costly, and borrowing costs are large in absolute terms.

How do interest rates affect durable consumer goods purchases?

Higher rates reduce spending on credit-financed goods like autos and houses; lower rates increase it.

What does Figure 15.2c show about investment and aggregate demand?

Higher investment shifts aggregate demand rightward:

• $15B investment → AD₁

• $20B investment → AD₂

• $25B investment → AD₃

If the money supply is $150B (S_m2), what is the equilibrium interest rate and investment?

Interest rate = 8%; Investment = $20B.

What equilibrium GDP results from $20B investment at 8% interest?

Real GDP = $900B (Q_f), Price level = P_2.
Qf —> full employment

Why do different money supply levels in Figure 15.2a lead to different GDP outcomes?

Because each money supply level sets a different equilibrium interest rate, which changes investment spending, shifts aggregate demand, and alters equilibrium real output.

Why are price levels considered downwardly inflexible in the real world?

Because prices resist falling, so aggregate supply is horizontal to the left of full-employment output Q_f.

What happens if the money supply falls to $125B (S_m1)?

AD shifts left to AD_1, real GDP falls to $880B, creating a recessionary gap and unemployment.

What actions can the Fed take to institute expansionary monetary policy?

Positive forward guidance, lowering IORB and ON RRP rates, and quantitative easing (bond purchases).

How do these expansionary actions increase the money supply?

More loans extended, fewer reserves held at the Fed, and new money created to buy bonds.

If money supply rises from $125B to $150B, what happens to interest rates and investment?

Interest rate falls from 10% to 8%; investment rises from $15B to $20B.

With MPC = 0.75, what is the multiplier and effect of a $5B investment increase?

Multiplier = 4; AD shifts rightward by $20B, eliminating the $20B GDP gap.

What is the ultimate outcome of expansionary monetary policy in recession?

Real GDP rises back to full-employment level Q_f=\$ 900B, eliminating the recessionary gap

When is restrictive monetary policy appropriate?

When the economy exceeds full employment, creating inflationary pressure.

What happens if money supply expands to $175B (S_m3)?

Interest rate = 6%; investment = $25B; AD shifts to right ; GDP rises to $910B, creating a $10B inflationary gap.

What actions can the Fed take to institute restrictive monetary policy?

Negative forward guidance, raising IORB and ON RRP rates, and quantitative tightening (bond sales).

How do these restrictive actions reduce the money supply?

Fewer loans extended, more reserves locked in Fed vaults, and money removed via bond sales.

Why can’t the Fed simply cut money supply back to $150B (S_m2)?

Because prices are inflexible at P_3, shifting AD back to AD_2 would cause recession (output below $900B).

What is the correct adjustment to eliminate the inflationary gap?

Reduce money supply to $162.5B (S_m4), raising interest rate to 7%, lowering investment to $22.5B.

How does the multiplier amplify the restrictive policy effect?

$2.5B drop in investment × multiplier of 4 = $10B leftward shift in AD, restoring GDP to $900B.

What is the ultimate outcome of restrictive monetary policy in inflation?

Real GDP returns to full-employment level Q_f=\$ 900B, eliminating the inflationary gap.

What happens when the money supply is low (e.g., $125B)?

Interest rates are high (10%), investment is low ($15B), aggregate demand is weak, and GDP falls below full employment ($880B). This creates recession and unemployment.

How does expansionary monetary policy fix recession?

The Fed increases the money supply, which lowers interest rates, raises investment spending, shifts aggregate demand rightward, and restores GDP to full employment ($900B).

What tools does the Fed use for expansionary policy?

Positive forward guidance, lowering the federal funds target, reducing IORB and ON RRP rates, and quantitative easing (bond purchases).

What happens when the money supply is too high (e.g., $175B)?

Interest rates are very low (6%), investment is high ($25B), aggregate demand is excessive, GDP rises above full employment ($910B), and inflation occurs.

How does restrictive monetary policy fix inflation?

The Fed decreases the money supply, which raises interest rates, reduces investment spending, shifts aggregate demand leftward, and brings GDP back down to full employment ($900B).

What tools does the Fed use for restrictive policy?

Negative forward guidance, raising the federal funds target, increasing IORB and ON RRP rates, and quantitative tightening (bond sales).

Why must the Fed be careful when reducing the money supply?

Cutting too much would push GDP below full employment, causing recession. The goal is to reduce demand just enough to eliminate the inflationary gap.

What is the ultimate goal of expansionary policy?

Raise GDP from below full employment to the full‑employment level, reducing unemployment.

What is the ultimate goal of restrictive policy?

Lower GDP from above full employment back to the full‑employment level, reducing inflation

The ____ interest rate is the rate at which the amount of money demanded and the amount supplied are equal.

Equilibrium

An increase in the money supply will do which of the following?

• Increase investment

• Increase aggregate demand

_____ monetary policy will increase the interest rate in order to reduce borrowing and spending, which will curtail the expansion of aggregate demand and hold down price-level increases.

Restrictive

Changes in the interest rate mainly affect the _______component of total spending, and also affect spending on durable consumer goods that are purchased on credit.

investment

Issuing positive forward guidance, lowering the effective federal funds rate, lowering the IORB and ON RRP rates, and purchasing government bonds as part of QE are all actions the Fed may take to _____ money supply

increase

During times of rising inflation the Fed will undertake which of the following monetary policies?

Restrictive

The Fed will enact restrictive monetary policy when aggregate demand is _______ in relation to the economy's full-employment level of real output. (Enter one word in the blank.)

Higher

With _____ monetary policy, the Fed will announce a higher federal funds target range, raise the IORB and ON RRP rates, or sell longer-term government securities.

restrictive

Which of the following are actions that the Fed may take to decrease the money supply?

• Raise the effective federal funds rate

• Sell government bonds as part of QT

A high interest rate environment will have which of the following effects?

• Lowering aggregate demand

• Discouraging investment

• Restraining demand-pull inflation

Which of the following are functions of restrictive monetary policy?

Increase interest rates

Curtail the expansion of aggregate demand

The rate at which the amount of money demanded and the amount supplied are equal is called what?

Equilibrium interest rate

Which portion of total spending is influenced the most by interest rate changes?

Investment expenditure

Which actions can the Fed plan in order to engage in restrictive monetary policy?

• Increase the IORB and ON RRP rates

• Sell longer-term bonds as part of quantitative tightening

Which of the following are actions that the Fed may take to increase the money supply?

• Lower the IORB and ON RRP rates

• Lower the effective federal funds rate