Central banks can use interest rates to change inflation rates. This is because the interest rate affects two determinants of aggregate demand (AD): Consumer Spending (C) and Investment (I).
Therefore, a change in C and I will cause a shift in AD, leading to a change in price levels.
- The central banks can use two types of monetary policy:
- Expansionary Monetary Policy
- Contractionary Monetary Policy
Expansionary Monetary Policy
Expansionary monetary policy, also sometimes referred as easy monetary policy, is used by central banks when an economy is having a deflationary gap and it is producing below the potential output.
- Observing the New Classical model, the economy currently produces at $Y_{rec}$, at the price level $PL_1$.
- As $Y_{rec}< Y_p$, the economy is in a deflationary gap, and is producing below its potential output level.
- Therefore, central banks implement expansionary monetary policy by decreasing the interest rates to encourage individuals to increase their spending and investments.
- This is because keeping money in savings does not provide high returns anymore.
- Due to this, the AD shifts from $AD_1$ to $AD_2$, increasing the total output ($Y_{rec} \rightarrow Y_p$) . This also causes the price level to increase to $PL_2$.
- With this, the deflationary gap is removed and the economy returns to its full-employment level of output.
- The same theory applies to the Keynesian model, where by decreasing the interest rates, the aggregate demand increases from $AD_1$ to $AD_2$.
- This increases the total output from $Y_{rec}$ to $Y_p$ and the price level from $PL_1$ to $PL_2$.
Contractionary Monetary Policy
Sometimes also referred to as tight monetary policy, it is implemented by the central bank when an economy is at an inflationary gap and is producing above its potential output.
