We will now look at monetary policy. We will start with the economy in a recession which is identified by price level one in quantity one. The Federal Reserve, which is the government entity that controls much of monetary policy, is faced with a stagnant economy with high unemployment. Therefore, they would use an expansionary money policy which would help to correct the situation. By increasing the money supply and decreasing the interest rate businesses and consumers would be able to borrow more money. By increasing consumption and investment aggregate demand would shift to the right. The economy would achieve a new equilibrium at a higher price level and a higher output.
Let's now start the economy which is experiencing high inflation which is once again identified as price level one and quantity one. The Federal Reserve, when it is faced with high inflation, would use a contractionary monetary policy to take money out of the economy to correct the situation. By decreasing the money supply, and increasing interest rates, it will cost businesses and consumers more to borrow money. By decreasing consumption and investment, aggregate demand would shift to the left. The economy would achieve a new equilibrium at a lower price level and a lower output.
