Chapter 17
Monetary policy measures within the Monetary Model

Monetary policy measures, i.e. changes in interest rates or money supply, can be divided into two categories: restrictive and expansive monetary policy. Restrictive monetary policy reduces the money supply at higher interest rates. Expansive monetary policy increases the money supply with lower interest rates. Using the slider you can select both expansive and restrictive monetary policy measures.

Due to the money market equilibrium ($M^S=M^D=\mathit{kPy}$) , a change in the money supply leads to a shift in the money demand curve. Thus, with a constant equilibrium output $y$ , the price level changes in the same direction from $P_0$ to $P_1$. The exchange rate $S_0$ then adjusts to the new equilibrium $S_1$ via the foreign exchange market.

However, this adaptation process should be looked at in greater detail. For this purpose, we use the example of an expansive monetary policy. If the money supply is increased, the money demand curve shifts outwards. This measure will lead to higher prices and a depreciation over the medium term. However, prices and exchange rates adjust at different times and thus, bring about the transition to a new equilibrium.

Shock: $M$ rises $\Rightarrow$ Money demand curve shifts outwards.

Step 1: Since foreign exchange markets react very quickly and exchange rates adjust very quickly, the exchange rate will fall to the new equilibrium rate $S_1$ shortly after the monetary policy measure. The prices, on the other hand, are inert and will not change at first. In the new situation $S_1∕P_0$, the domestic economy has a competitive advantage and can significantly increase exports.

Step 2: This increases the demand for domestic goods and, as a result in the medium term, also production. $y_0$ rises to $y_1$, while prices still remain unchanged.

Step 3: Wage and price pressures arise. Due to the over-utilization of the economy, both costs and wages increase. This is partly passed on to prices, which is possible due to the higher overall demand. The price level is slowly rising. This reduces the competitive advantage again and the economy slowly returns to equilibrium (but at a higher price level $P_1$).

Conclusion: After the adjustment process, the domestic economy is back in balance with the long-term equilibrium income. Hence, monetary policy cannot generate sustainable or long-term growth impulses. However, it can temporarily boost the economic activity, for example to compensate for other negative shocks. The effect of the positive growth spurt always fades after some time. Only the effect on the price level is permanent. The price level has risen compared to the initial equilibrium, i.e. inflation has occurred.

In the case of restrictive monetary policy, the signs are reversed: depreciation to appreciation, GDP growth to GDP decline, inflation to deflation.