Survey of Economics – Monetary Policy & Dynamic AD-AS

Twenty question-and-answer flashcards reviewing key features of static vs. dynamic AD-AS models, expansionary and contractionary monetary policy, Fed tools (open-market operations), and expected effects on GDP, inflation, and unemployment.

What key assumption about potential GDP differentiates the dynamic AD-AS model from the basic (static) AD-AS model?

The dynamic model assumes potential GDP grows every year, while the basic model treats potential GDP as fixed.

When is expansionary monetary policy typically used in the basic (static) AD-AS model?

When aggregate demand falls and the economy is operating below full-employment output.

In the dynamic AD-AS model, under what condition will the Fed pursue expansionary monetary policy?

When aggregate demand is not growing fast enough to keep actual GDP at potential GDP.

If actual real GDP is above potential GDP, what kind of monetary policy should the Fed adopt in the dynamic model?

Contractionary monetary policy to slow spending and reduce inflationary pressure.

How does a contractionary monetary policy usually affect the inflation rate?

It lowers the rate of inflation and can even cause the price level to fall if demand drops sufficiently.

Which open-market operation corresponds to an expansionary monetary policy?

An open-market purchase (buying) of Treasury bills by the Fed.

Which open-market operation corresponds to a contractionary monetary policy?

An open-market sale (selling) of Treasury bills by the Fed.

If the Fed successfully keeps real GDP at potential with expansionary policy, how will unemployment compare with a no-policy scenario?

Unemployment will be lower than it would have been without the policy.

If the Fed keeps real GDP at potential through expansionary policy, how will the inflation rate compare to no policy?

The inflation rate will be higher than it would have been without the policy.

True or False: A contractionary policy must cause the overall price level to fall.

False. It may simply slow the rate of inflation rather than reduce the price level.

Why is the statement “Because the U.S. price level hasn’t fallen since the 1930s, the Fed hasn’t used contractionary policy since then” incorrect?

Contractionary policy can lower the inflation rate without causing an outright decline in the price level.

In a dynamic AD-AS diagram, moving from point B (actual GDP above potential) back to long-run equilibrium typically requires what Fed action?

An open-market sale of government securities (contractionary policy) to reduce aggregate demand.

In a dynamic AD-AS diagram, moving from point B (actual GDP below potential) to long-run equilibrium typically requires what Fed action?

An open-market purchase of government securities (expansionary policy) to boost aggregate demand.

What two features make the dynamic AD-AS model more realistic than the basic model?

(1) Continuous inflation (price level rises every year) and (2) long-run economic growth (LRAS shifts right every year).

If the Fed believes aggregate demand will not keep up with a growing potential GDP, what policy will it most likely pursue?

Expansionary monetary policy to stimulate spending and close a potential recessionary gap.

True or False: Expansionary monetary policy aimed at closing a recessionary gap will result in a lower inflation rate than doing nothing.

False. Expansionary policy generally raises the inflation rate relative to no policy.

During 2005 the Fed responded to a booming housing market by lowering the federal funds rate. True or False?

False. Concerned about rising inflation, the Fed actually raised the target federal funds rate (a contractionary move).

In the table for 2022–2023, real GDP is projected below potential. What policy should the Fed use to keep GDP at potential?

Expansionary monetary policy—specifically, buying Treasury bills to shift aggregate demand rightward.

If the Fed’s expansionary policy is successful in 2023, what happens to actual real GDP compared with no action?

Actual real GDP will be higher than it would have been without Fed action, matching potential GDP.

If the Fed’s expansionary policy is successful in 2023, what happens to potential (full-employment) GDP compared with no action?

Potential GDP remains the same; expansionary policy does not affect the economy’s productive capacity.