Question

2. (12 marks) Use a AD/AS diagram to illustrate the use of expansionary monetary policy to close an expansionary gap. a. Label the axes. b. Label the lines. And show the expansionary gap with the LRAS c. Show the new AD line after the expansionary monetary policy is applied. d. Briefly explain what your diagram shows. e. Explain what monetary policies impact. LRAS SRAS Poh t AD2 recessiona

Answer 1

f the Fed engages in expansionary monetary policy to
combat a recessionary gap, the increase in the money
supply will lower the interest rate. The lower interest
rate reduces the cost of borrowing and the return to
saving. Therefore, firms invest in new plant and equip-
ment, while households increase their investment in
housing at the lower interest rate. In short, when the
Fed increases the money supply, interest rates fall and
the quantity demanded of goods and services increases
at each and every price level. The aggregate demand
curve shifts from AD1
to AD2
, as seen in Exhibit 1.
The result is greater RGDP growth at a higher price
level at E2
. In this case, the Fed has eliminated the
recession, and RGDP is equal to the potential level
of output at RGDPNR. During the recession of 2001,
the Fed aggressively lowered the federal funds rate to
stimulate aggregate demand when it was faced with a
recessionary gap.

LRAS SRAS e9