In this diagram here on the right, you can see the movement of the money supply
that we saw as we were talking about the different tools of central banks.
And you can see that step one is for the central bank
to increase this money supply in the particular case we're looking at.
So money supply goes from the blue line to the red
line through one of those three tools that we've just mentioned.
The second thing that happens, which we also
just saw, is that the interest rate responds.
Now sometimes the interest rate doesn't respond, so
we may have trouble right here at the beginning.
But let's assume it responds, okay?
The central bank increases the supply of money.
The equilibrium interest rate in these free financial markets falls.
Okay?
Response to the monetary policy, all right?
And then we move to the graph on the right.
When the interest rate falls, if you think it through, and
you think about the aggregate demand elements that we talked about
a couple of weeks ago, you realize that the one that's
going to respond the most to a lower interest rate is investment.
Right?
We have, when we look at aggregate demand, we have
consumption, investment, government spending, and x minus m, or net exports.
Remember we has c plus i, plus g, plus x minus m.
Well it's the i, private investment, that's going to
respond most strongly to this lower interest rate.
This is people buying houses, this is corporations building projects.
So if the interest rate goes down, on the right hand graph we
will see aggregate demand shifting out
to the right, because there's additional investment.
So, so far the chain of events is, change the money supply, change
the interest rate, change aggregate demand through this move in investment.
All right?
The next thing that will happen is that GDP will change.
So it's kind of a four step process from that change in
the money supply until we get out to the change in GDP.
So what does the central bank want to do with GDP?
Well, just like fiscal authorities should do, the central bank wants to bring the
economy toward potential GDP, because remember every
central bank is trying to control inflation.
Even if it has a single mandate, it's trying to control inflation.
Now we know that when the economy
goes into an inflationary gap, inflation will accelerate.
So what the Central Bank is going to want to do is
bring GDP growth back down to potential so that inflation will decline.
So, in a period where the economy is growing
very fast and we are in an inflationary gap,
in a period of inflationary gap or positive output
gap, the central bank will want to raise interest rates.