Question

Demonstrate the effect of expansionary monetary policy in the AS/AD model when the economy is:

a) Below potential output.
b) Significantly above potential output.

Answer 1

Expansionary monetary policy can help the economy return to potential GDP by stimulating investment and consumption spending.

Step-by-step explanation:

If the economy is suffering a recession and high unemployment, with output below potential GDP, expansionary monetary policy can help the economy return to potential GDP. This is illustrated in Figure 6 (a) using a short-run upward-sloping Keynesian aggregate supply curve (SRAS). The original equilibrium during a recession of Eo occurs at an output level of 600. An expansionary monetary policy will reduce interest rates, stimulate investment and consumption spending, and shift the original aggregate demand curve (AD) to the right (AD₁), resulting in a new equilibrium (E₁) at the potential GDP level of 700.