Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Contractionary monetary policy

To carry out a contractionary monetary policy, the central bank reduces the money supply (typically by selling government bonds; for more on the exact process, flip to Chapter 10). The reduction in the money supply drives up the interest rate. A higher interest rate means lower consumption, investment and net exports, and because these are all components of aggregate demand, AD falls. We don’t reproduce all the diagrams for these because they’re exactly the opposite of the expansionary monetary policy ones! We show the AD–AS diagram for contractionary monetary policy in Figure 9-12.

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Figure 9-12: Contractionary monetary policy: AD–AS.

In Figure 9-12, contractionary monetary policy has reduced aggregate demand from AD₁ to AD₂, which in the short run causes output and the price level to fall (the movement from point A to point B). Owing to sticky prices in the short run, the price level falls relatively little and output falls relatively

a lot. In the long run, prices become flexible and the SRAS curve shifts down and to the right. This move reduces the price level and increases output until eventually output is unchanged at point C.


Increasing demand with the multiplier effect

As well as monetary and fiscal policies impacting directly on aggregate demand, there are also second-order (and third-order and higher) effects.

We’re talking here about something called the multiplier effect. Any

positive shock to AD increases output (Y) in the short run (see, for example, Figure 9-11). But consumption itself is a function of disposable income, C(Y – T): when disposable income increases, consumption increases. Therefore the initial increase in output increases consumption, which increases aggregate demand further. This is the second-order effect. But then this second-order increase in aggregate demand increases output by a little bit more, which in turn increases consumption a little, which shifts AD further and so on. Hence the name, the multiplier effect. Ultimately these effects get smaller and smaller and eventually peter out.

In Figure 9-13, you can see that initially aggregate demand increases from AD₁ to AD₂, but due to the multiplier effect, aggregate demand increases further, to AD₃, and keeps increasing through successive rounds until eventually it stops at AD_~. The same idea applies to a fall in aggregate demand: the initial fall in AD reduces output, which reduces consumption, which reduces AD further and so on. As a result, the short-run change in output and the price level is greater than it would otherwise be. However in the long run, when prices are flexible, output still returns to its natural level, although at a higher price level.

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Figure 9-13: Multiplier effect: multiple rounds of AD increase.


Suppose that the government increases expenditure (G) by £1 million, directly increasing output in the short run by £1 million. This extra £1 million is spent on goods and services, which increases the incomes of the producers of those goods by £1 million. Some portion of this additional income will be spent. You can write the consumption function as follows:

so an increase in income (Y) of £1 million increases consumption by c₁ × £1 million (the second-order effect). But this increase in consumption further increases income by c₁ × £1 million, which increases consumption by c₁ × c₁

• 
  £1 million (the third-order effect). These rounds of effects continue so that the overall impact on output is equal to:
  

Mathematicians call this an infinite geometric series and thankfully you can sum all these terms in a very easy way:

Notice that the larger the marginal propensity to consume (c₁), the greater is the total impact on output when some component of aggregate demand increases. Equally, when the marginal propensity to consume is low, the successive rounds of extra consumption become very small very quickly. The expression 1/(1 – c₁) is called the multiplier, because it multiplies up any initial increase (or decrease!) in aggregate demand.