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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.

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We would call this chain of events a restrictive monetary policy.

Just like we talked about restrictive

fiscal policy, there's a restrictive monetary policy.

And its objective is to restrict activity in the

economy so that it goes toward potential, becomes more stable.

Okay?

Now the opposite situation would be for the

central bank to want to expand the economy.

And that would happen if the economy is in a

recessionary gap, that we identified a couple of weeks ago.

So GDP growth is too low in a recessionary

gap, and the central bank wants to bring it up.

How does it do that?

Well it goes through the same chain of events The

only thing it can do is influence the money supply.

So in this case, and it's the one illustrated on the graph, in this

case it would increase the supply of money through one of its three tools.

The result would be for the interest rate to fall.

6:20

What they're saying, and this is a simple way to understand monetary policy.

What they're saying is, if the real growth rate of GDP is

the same as the real interest rate, which is that interest rate

in our graph minus inflation, okay, so we take the interest rate

in that free market, and we adjust it for the inflation rate.

So they're saying if the real growth rate of GDP without inflation is about equal to

the real interest rate, the interest rate without

inflation, then monetary policy isn't doing anything, it's neutral.

7:22

the real interest rate, then monetary policy's effect is expansive.

It's giving room for the economy to grow more and for GDP to move up to potential.

So, if we look at these pictures you can see, starting with Germany,

this is between 1991 and 2011 the red line is the real interest rate.

So that's the interest rate that the central bank was

targeting in that free financial market minus the inflation rate.

Okay?

And the other line is the growth rate of GDP.

Now, we don't know if there's inflationary or recessionary gaps here.

We can guess.

But I just want you notice the relationship

between the interest rate and the GDP growth rate.

And you can see in this early period up

to about 2005 the interest rate, the real interest

rate is higher than the real GDP growth rate,

which means that had a restrictive effect on the economy.

So the central bank was trying to slow

down the economy, trying to get inflation down.

Okay.

Then we see in the period after 2005 there's a little bit more variety.

So, we see right away that the interest rate is below the real GDP growth rate.

Which would mean it would have an expansion affect.

Then we see it above again, and then we see it below.

We can look at some other countries here.

So if we look at for example Japan, you

can see the chart for Japan where the real interest

rate is again in their early period above the

real GDP growth rate indicating that that policy was restrictive.

And then in the later period we see

sometimes where it's below the real GDP growth rate.

However, you can notice, you see this with both Japan and Germany.

When the economy is deep in recession, as it was in 2009,

you can't get your interest rate below a negative GDP growth rate.

So this is one of the limits of

monetary policy, you can't go into negative numbers, okay?

And then you can see, for example if we look at China,

okay, we see the chart for China and we can see again that

there are moments in fact the entire period, if you look at this chart

where the real interest rate is below the real GDP growth rate.

So monetary policy in this whole period is expansive for China.

So this is an interesting thing to try to compare to see how central banks

are acting in different economies, and sometimes