Principles of Macroeconomics / Unit 18 MAC 1712 worked example, 60 to 90 seconds
Any Policy: Tool to Output and Prices
The idea
Take any policy action and follow it to real GDP and the price level, naming every link. Skipping a link is how errors enter, because most mistakes happen in the middle and an unstated middle cannot be checked.
In practice
The central bank sells bonds. Reserves in the banking system fall. The federal funds rate rises, and other rates follow it up. Higher rates reduce investment and purchases of durable goods, and they raise the currency's value, which reduces net exports. Aggregate demand shifts left by the multiplier times those initial changes. Output falls and the price level falls. Now a fiscal case: the government raises purchases. Aggregate demand shifts right by the multiplier times the increase, partly offset by higher interest rates reducing private investment. Output rises; the price level rises.
Where people slip
Both traces end at the same two variables, which is the point of having one order. Note also what the second trace contains that the first does not: a fiscal expansion has to be financed, so it works partly against itself through the interest rate. Unit fifteen called that crowding out, and it is why the two instruments are not interchangeable.
Your place on the trail
Every lesson rests on earlier ones and opens later ones. Tap any to jump.
Something wrong in this lesson? Flag it · Sources for Principles of Macroeconomics