Monetary Policy Graphs (2 of 2) - Macro 4.6 - Hey, how are you doing. This is Mr. Clifford. This is ACDC Econ. It's time to finish up and talk about the money market and how it affects aggregate demand. Now, the last video we actually showed this concept, except we showed it with a recessionary gap. Now, this time take a look. We have an inflationary gap, right. Our actual GDP is well above our potential GDP. What does the Fed want to do? Well, that's your job show me. On this graph, the Fed is going to increase or decrease my supply. That's going to change investment. Investment is a component of aggregate demand, and somethings going to happen over here. Your job is to be able to explain what's going to happen. I want you try to on your own. Good luck. All right, you got it? You know what's going happen? Let's find out, all right. First, we know the Fed is going to decrease the money supply. Decrease in money supply will lead to higher equilibrium interest rates. That higher interest rate right here, interest rate one, is going to decrease the quantity of investment. Now, that's important, because investment is a component of aggregate demand. When investment decreases-- the reason why is a higher interest rate-- firms like, eh, I'm not going to go borrow money. I'm not going to increase the size of my factory. I'm not going to go do those things. Because the interest rates are so high, I don't want to go out and borrow it. So higher interest rates, higher interest rates decrease investment. That would cause aggregate demand to shift to the left. When aggregate demands shift to the left, it actually closes this gap and solves the problem. Now, I'll show it to you down here. What happened was this, a decrease in the supply of money led to an increase in interest rates. When interest rates went up, that led to a decrease in investment. A decrease in investment led to aggregate demand going down. So all these things, right, happened, chain-link events, and make sure you don't leave any of them out. You can't just say supply demand goes down so aggregate demand goes down. It's true, but we have to explain the process and the steps that occurred to make that happen. And you know it's keep happening here. The according to the graph, the price level goes down, and the quantity also goes down. OK, time for a bonus round. There are three things the Fed could do to decrease the money supply. We learned it in the previous video. The question is, what are the three things? Well, the Fed could first increase the reserve requirement. They could increase the discount rate, or they could sell bonds. When the government does any one of these three things, it decreases the supply of money and that is called monetary policy. This is just monetary policy, adjusting the money supply to affect interest rates to change aggregate demand to close a recession or in this case an inflationary gap. Hopefully, it makes sense until next time.