Macroeconomic Policy and Market Equilibrium Notes

Impact on the Money Market: - In an economy experiencing an inflationary gap, the central bank (Federal Reserve) can intervene by decreasing the money supply ( $MS$ ). - This shift is represented graphically by the money supply curve ( $MS_1$ ) shifting to the left ( $MS_2$ ). - The reduction in the quantity of money available leads to an increase in the nominal interest rate ( $IR$ ). - Graphically, this is shown as a movement from $IR_1$ to $IR_2$ along the vertical axis of the Money Market graph.
Transmission to the AD/AS/LRAS Model: - The increase in interest rates resulting from the contractionary monetary policy ( $MS \downarrow \implies IR \uparrow$ ) lead to a decrease in interest-sensitive components of spending, such as investment and consumption. - This causes the Aggregate Demand curve ( $AD_1$ ) to shift to the left ( $AD_2$ ). - The shift in Aggregate Demand results in a lower price level, moving from $PL_1$ to $PL_2$ . - Real GDP ( $Y$ ) decreases from its inflationary output level ( $Y_2$ ) back toward the full employment output ( $Y_1$ ) marked by the Long-Run Aggregate Supply ( $LRAS$ ) curve.

Nature of a Recessionary Gap: - In a recession, actual output is below the potential output level of the economy. - The primary objective of policy is to increase Aggregate Demand ( $AD$ ) to close the output gap.
Fiscal Policy Response: - Fiscal policy involves government-led changes to spending and taxation. - To close a recessionary gap, the government can either increase government spending or decrease taxes to stimulate demand.
Monetary Policy Comparison: - Unlike fiscal policy, which affects demand directly through government spending, monetary policy works indirectly by influencing interest rates and the availability of credit. - In a limited reserves environment, the central bank uses specific tools to manage these rates.
Three Primary Tools of the Central Bank for Recession Recovery: - Open Market Operations: Purchasing government bonds to increase the money supply and lower interest rates. - Discount Rates: Lowering the rate at which commercial banks can borrow money from the central bank. - Reserve Requirements: Lowering the percentage of deposits that banks are required to hold in reserve, thereby increasing their capacity to lend.

Objective of Contractionary Policy: - When an economy is experiencing high inflation, the goal is to reduce Aggregate Demand. - Contractionary monetary policy is preferred in certain contexts over fiscal policy for fighting inflation due to its relative speed and insulation from political cycles.
Three Tools to Fight Inflation: - Open Market Operations (Selling Bonds): The central bank sells government bonds to the public, which removes money from the banking system and reduces the money supply. - Increasing Discount Rates: Raising the interest rate for borrowing from the central bank makes it more expensive for commercial banks to acquire funds, putting upward pressure on market interest rates. - Increasing Reserve Requirements: Raising the reserve ratio forces banks to hold more cash on hand and lend out less, effectively tightening the money supply.
Impact on Economic Behavior: - These actions increase the cost of borrowing, which directly discourages and reduces both investment and consumption spending by businesses and households.

Self-Correction in a Recession: - In the absence of government or central bank intervention, an economy can eventually return to full employment through internal adjustments. - During a recession, the persistence of low demand puts downward pressure on wages. - As nominal wages decrease, the costs of production for firms fall. - This reduction in production costs causes the Short-Run Aggregate Supply ( $SRAS$ ) curve to shift to the right. - The economy eventually returns to the Long-Run equilibrium output level.
Self-Correction in an Inflationary Gap: - When the economy is producing above full employment (inflationary gap), there is a high demand for labor. - This high demand eventually pushes nominal wages up. - Rising wages increase the overall costs of production for firms. - In response to higher costs, the Short-Run Aggregate Supply ( $SRAS$ ) curve shifts to the left. - Consequently, output decreases until the economy returns to its Long-Run equilibrium at full employment.