Monetary Policy and Inflation Dynamics





Monetary Policy and Inflation Dynamics

This business article highlights the relationship between the monetary policy and inflation dynamics. The theoretical arguments and statistics provided in this article are useful in reviewing the claim that low inflation in the United States is an option that depends on the principles and policies adopted by the Federal Reserve. For instance, the Fed’s objective of controlling the interest rate on a short-run basis is in accordance with its efforts to lower the inflation rate to 2% through a long-run approach (Monetary Policy: Low Inflation Is a Choice). According to the information provided in this article, such economic proceedings are an indication of the limitations present in the monetary policy. However, the mandate of the Federal Reserve inclines towards headline inflation as opposed to core inflation. For this reason, they use the elements of core inflation as an economic indicator since the headline inflation recorded in the past is less effective in predicting the future levels of inflation.

The elements discussed in this business article highlight the principles of monetary policy and its effects on the AS-AD model. By integrating the operations of the Fed in this discussion, it is evident that monetary policies are guidelines used by the government of a country with the main aim of influencing the operations within the financial system of the nation (Monetary Policy: Low Inflation Is a Choice). This includes the modification of the interest rates in commercial banks and other financial institutions. Accordingly, financial analysts such as Harry Johnson and Milton Friedman have used various theoretical perspectives to put emphasis on the existing relationship between these manipulations and the level of inflation experienced in a country (Mankiw 52). Based on their argument, monetary policy is effective in controlling the recurring instabilities in the national economy. This is because of the existing loopholes in the demand-management principles with reference to its ability to control currency and credit supplies.

Prior to the shifts on the AS-AD model following the implementation of monetary policy, the intersection of the long-run aggregate supply, short-run aggregate supply, and short-run aggregate demand curves indicates the equilibrium price and output levels. The Federal Reserve and consumers in the local and global markets may be responsible for this alteration of the short-run aggregate demand. Its expansionary principles result in a shift towards the right while reduction policies with reference to currency supplies result in the repositioning of this curve to the left (Mankiw 60). Subsequently, the long-run aggregate supply encounters manipulation from monetary policy and other production factors. This sways the short-run aggregate supply to the left. This alteration portrays the price level as the only influential factor in determining the stability of the short-run aggregate demand.

The graph below is useful in explaining this theoretical perspective regarding the effect of monetary policy on the AS-AD model. In this scenario, the point of reference is the long-run equilibrium based on the intersection of the long-run aggregate supply and short-run aggregate demand curves. Based on this argument, an expansionary policy formulated and implemented by the Federal Reserve with reference to monetary policy will result in the alteration of the short-run aggregate demand curve to the right.  This will also include the shifting of the short-run equilibrium from point A to B. This modification paves way for the increase in price and output levels.

However, on the long-term basis, the projected and real price levels are comparable. This is because the monetary policy propels manufacturers, commercial organizations, and their human resources to modify their expectations in order to comply with the set measures and facilitate the attainment of low inflation rates. Consequently, the short-run aggregate supply curve moves along the short-run aggregate demand curve to point C, which illustrates an intersection of the three main curves (Mankiw 66). Based on these findings, it is correct to state that the implementation of an expansionary policy formulated by the Federal Reserve regarding monetary policy results in an increase of price and output levels on a short-term basis. However, an evaluation of the long-term effects of such monetary policy highlights that only the price level increases.


Figure 1: expansionary policy and its effects on the AS-AD model


In terms of the relationship highlighted in this business article and the subsequent theoretical evaluation on inflation and monetary policy, certain shocks in the national economy are somewhat responsible for this correlation. In a normal scenario, the short-run aggregate demand curve easily shifts due to the influence of production while the short-run aggregate supply curve hardly exhibits any alteration. Nonetheless, a supply shock propels this curve to shift significantly without any form of instigation from the short-run aggregate demand curve. One such shock is the adverse supply shock (Mankiw 71). This entails such aspects as famine and the resultant crop failure, increased oil prices, and protests or other firm actions from labor unions. Such factors are the source of the augmentation in price levels for a specified output quantity. In a graphical representation as the one illustrated below, such a scenario equates to a left-hand movement of the short-run aggregate supply curve.

Figure 2: adverse supply shock and the subsequent alterations in the AS-AD model


In addition, a similar shift occurs regarding the intersection between the short-run aggregate demand and supply curves. The acquired short-run equilibrium indicates an increase in the price levels following a decrease in output levels through the process of stagflation. Nonetheless, as part of the long-term transformations, the short-run aggregate demand changes in order to concur with the new output and price levels (Mankiw 89). This alteration triggers a shift of the short-run aggregated demand curve along the short-run aggregate supply curve in order to acquire the long-run equilibrium. Similar to the expansionary policy of the Federal Reserve, this modification process with reference to monetary policy and the inflation rate in a country illustrates different outcomes of the short-range and long-term basis. Price levels increase as output levels decrease in the short-term framework while only the price levels augment in the long-term evaluation of the policy implementation process (Monetary Policy: Low Inflation Is a Choice).

These theoretical evaluations concur with the economic fluctuations experienced in the United States in the recent past. Accordingly, a comparison between these two aspects justifies the claims made in this business article. For instance, between 1970 and 2008, there was a significant fluctuation in the labor and capital resources available for the growth of the national economy. This is evident in the comparison between the predicted and actual Gross Domestic Product of this country (Mankiw 79). This explains why the Federal Reserve and economic analysts use elements of the AS-AD model to understand the price and output levels and the factors that lead to their modifications. Theoretical concepts such as Okun’s Law ease the process of using these findings to explain rates of inflation and unemployment in the country during such periods of financial depression.

In the United States, these periods of financial developments have instigated the implementation of certain monetary policy techniques by the Federal Reserve. For example, the frequent increase in oil prices has led this national agency to adjust interest rates based on the short and long-term effects of this modification process (Monetary Policy: Low Inflation Is a Choice). At the onset of this inflation, the implemented monetary policy aims at shifting the short-run aggregate demand curve to its natural state by augmenting interest rates and lowering currency supplies within the nation.  The reduction in investment activities highlights the accomplishment of this objective.

Figure 3: real and potential GDP for the United States (1970-2008)



In conclusion, the business article evaluated in this paper indicates the relationship between monetary policy and inflation. Theoretical aspects such as the AS-AD model indicate the various factors that result in alterations within different curves on a short and long-term basis. As indicated in the article, an expansionary policy formulated by the Federal Reserve is bound to trigger an increase in price levels with the output levels reducing significantly in the short-run. However, the long-term effect of such a policy is the increase in price levels with no major alteration in the output level. Such situations highlight the impact of the monetary policy in shaping the financial growth of a country. Moreover, these principles are useful in ending the financial fluctuations experienced in a country due to such internal factors as prolonged protests by members of the labor union in the country and external factor such as increase oil prices. However, a demand shock may limit the influence of the monetary policy since the Federal Reserve can only facilitate the movement of the short-run aggregate demand curve in order to avoid excessive increase in price levels.

Work Cited

Mankiw, N G. Monetary Policy. University of Chicago Press, 2007. Print.

Monetary Policy: Low Inflation Is a Choice. The Economist. Retrieved from:
















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