Monetary policy in the AD-AS model

Overview

Difference between demand-pull and cost-push inflation and vertical long-run aggregate supply curve represent.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Describe the AD-AS diagram showing the effect of a rise in interest rates.

   Model answer

   Put the general price level on the vertical axis and real national output on the horizontal, with a downward-sloping aggregate demand curve cutting an upward-sloping short-run aggregate supply curve at price level P1 and output Y1. Higher interest rates reduce consumption and investment and, through a stronger currency, net exports, so aggregate demand shifts left from AD1 to AD2. At the new equilibrium the general price level has fallen to P2 and real output has fallen to Y2, so inflationary pressure eases at the cost of lost output and rising cyclical unemployment.

2. 2

   Describe the AD-AS diagram showing the effect of a cut in interest rates.

   Model answer

   With the general price level on the vertical axis and real national output on the horizontal, cheaper borrowing and a lower reward for saving raise consumption and investment, and a weaker currency raises net exports, so aggregate demand shifts right from AD1 to AD2. Moving up the upward-sloping short-run aggregate supply curve, the new equilibrium has a higher price level P2 and higher real output Y2. Higher output raises the derived demand for labour, so employment rises.

3. 3

   Use AD-AS to explain what a rise in interest rates achieves in an economy operating at full capacity.

   Model answer

   On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, the long-run aggregate supply curve is vertical at the maximum sustainable level of output and short-run aggregate supply is very steep. A leftward shift of aggregate demand along that steep section therefore produces a large fall in the general price level and only a small fall in real output. Tightening is at its least costly here, because the demand being removed was pressing against a capacity ceiling and was showing up mainly as inflation.

4. 4

   Use AD-AS to explain why cutting interest rates during a deep recession may raise output with little inflation.

   Model answer

   On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, a deep recession appears as a large negative output gap, with unemployed workers and idle capital, so firms can raise production without bidding up wages and input prices and the short-run aggregate supply curve is close to flat over that range. A rightward shift of aggregate demand along the flat section therefore produces a large rise in real output and only a small rise in the general price level. The risk of inflation only becomes serious as the economy approaches the vertical long-run aggregate supply curve.

5. 5

   Analyse, using AD-AS, the effect of a cut in interest rates when the economy is already close to full employment.

   Model answer

   On a diagram with the general price level on the vertical axis and real national output on the horizontal axis, close to full employment the short-run aggregate supply curve is steep because extra output requires firms to compete for scarce labour and materials, and the vertical long-run aggregate supply curve is not far to the right of current output. The rate cut shifts aggregate demand right from AD1 to AD2, but most of the adjustment comes through a rise in the general price level from P1 to P2, with only a modest and temporary rise in real output. Once wages catch up with the higher price level, short-run aggregate supply shifts left and output returns towards capacity with a permanently higher price level.

6. 6

   A cut in interest rates also weakens the currency. Show on an AD-AS diagram how this affects both curves and what the combined result is.

   Model answer

   With the general price level on the vertical axis and real national output on the horizontal axis, the weaker currency raises net exports, reinforcing the rightward shift of aggregate demand from AD1 to AD2 caused by cheaper credit. At the same time imported raw materials, components and energy cost more in domestic currency, so firms’ costs rise and short-run aggregate supply shifts left from SRAS1 to SRAS2. Both shifts push the general price level up, so the inflationary effect is unambiguous and larger than the demand channel alone suggests, while the effect on real output is the net of a rightward demand shift and a leftward supply shift and is therefore smaller and less certain.

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