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Contractionary_Monetary_Policy_AD_AS_Model

The document discusses the effects of contractionary monetary policy on short-run and medium-run equilibrium using the IS-LM and AD-AS models. It explains how such policies lead to higher interest rates, reduced aggregate demand, and lower output in the short run, while in the medium run, price adjustments facilitate a return to natural output levels at lower price levels. The integration of both models provides a comprehensive understanding of the interactions between the goods market, money market, and aggregate demand and supply.

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4 views2 pages

Contractionary_Monetary_Policy_AD_AS_Model

The document discusses the effects of contractionary monetary policy on short-run and medium-run equilibrium using the IS-LM and AD-AS models. It explains how such policies lead to higher interest rates, reduced aggregate demand, and lower output in the short run, while in the medium run, price adjustments facilitate a return to natural output levels at lower price levels. The integration of both models provides a comprehensive understanding of the interactions between the goods market, money market, and aggregate demand and supply.

Uploaded by

vermashikha202527
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Effect of Contractionary Monetary

Policy on Short-run and Medium-run


Equilibrium in the AD-AS Model (Using
IS-LM Model)
Introduction to Contractionary Monetary Policy
Contractionary monetary policy refers to the actions taken by a central bank, such as
increasing interest rates or reducing the money supply, to reduce inflation and cool down
an overheated economy. This policy typically aims to decrease aggregate demand by
making borrowing more expensive, thus lowering consumption and investment. The effects
of contractionary monetary policy can be analyzed using both the IS-LM and AD-AS models,
which illustrate the short-run and medium-run impacts on output, price levels, and
employment. This paper explains these effects in detail, combining the IS-LM framework
with the AD-AS model, and provides a graphical representation of the changes in
equilibrium.

The IS-LM Model and Contractionary Monetary Policy


The IS-LM model is a macroeconomic framework that represents the relationship between
the goods market (IS curve) and the money market (LM curve). The IS curve shows
equilibrium in the goods market where investment equals savings, while the LM curve
represents equilibrium in the money market where money demand equals money supply.
Contractionary monetary policy directly affects the LM curve by reducing the money supply
or increasing interest rates, which shifts the LM curve upward, leading to higher interest
rates and lower output.

In the context of contractionary monetary policy, the central bank reduces the money
supply, causing the LM curve to shift leftward. As a result, interest rates rise, making
borrowing more expensive. This leads to a decrease in investment and consumer spending,
which reduces aggregate demand and lowers output in the short run. The IS curve remains
unchanged initially because the goods market is unaffected by monetary policy directly, but
the resulting higher interest rates decrease demand for goods and services, pushing the
economy into a new equilibrium with lower output.

Short-run Impact in the AD-AS Model


In the short run, contractionary monetary policy affects the AD-AS model by reducing
aggregate demand (AD). In the AD-AS framework, the aggregate demand curve represents
the total demand for goods and services in the economy at different price levels, while the
aggregate supply curve shows the total output producers are willing to supply. A decrease
in aggregate demand leads to a leftward shift of the AD curve.

In the short run, prices may be sticky, meaning they do not immediately adjust to changes in
demand. As a result, the immediate effect of contractionary monetary policy is a reduction
in output, with minimal impact on the price level. Firms respond to lower demand by
cutting production, which leads to a decrease in output and an increase in unemployment.
This creates a short-run equilibrium where the economy operates below its potential
output, with actual output lower than the natural level of output.

Medium-run Impact in the AD-AS Model


In the medium run, the economy adjusts to the effects of contractionary monetary policy.
Prices, which were sticky in the short run, begin to adjust downward in response to lower
demand. As prices fall, the real money supply increases, reducing interest rates and
encouraging more consumption and investment. This helps to gradually restore aggregate
demand.

In the AD-AS model, the short-run aggregate supply (SRAS) curve shifts to the right as firms
lower their prices and wages adjust. Over time, the economy returns to its natural level of
output, but at a lower price level. The medium-run equilibrium is characterized by restored
output, lower inflation, and potentially higher levels of unemployment compared to the
initial equilibrium.

Combining the IS-LM and AD-AS Models


The IS-LM model and the AD-AS model together provide a more comprehensive view of the
effects of contractionary monetary policy. In the short run, the IS-LM model shows how the
reduction in the money supply leads to higher interest rates and lower output, while the
AD-AS model illustrates the reduction in aggregate demand and output in response to
higher borrowing costs.

In the medium run, price adjustments in the AD-AS model help the economy recover its
natural level of output, while the IS-LM model reflects the eventual reduction in interest
rates as prices fall and the real money supply increases. The combination of both models
highlights the interaction between the goods market, the money market, and aggregate
demand and supply, demonstrating how monetary policy affects the economy over time.

Graphical Representation of the AD-AS Model


The following graph represents the short-run and medium-run impacts of contractionary
monetary policy in the AD-AS model. The initial leftward shift of the AD curve shows the
short-run reduction in output, while the rightward shift of the SRAS curve in the medium
run illustrates how the economy adjusts to restore output to its natural level.

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