Economics – Government and the macroeconomy - Monetary policy | e-Consult

Diagram:

The diagram should show a standard AD-AS model with the following elements:

• Axes: Y-axis represents the price level (P), and the X-axis represents real output (Y).
• AD Curve: A downward-sloping curve representing the aggregate demand curve.
• AS Curve: An upward-sloping curve representing the aggregate supply curve.
• Initial Equilibrium: The intersection of the AD and AS curves represents the initial equilibrium price level (P1) and real output (Y1).
• Shift in AD: A shift to the right of the AD curve, labeled AD2, representing the increase in aggregate demand caused by a decrease in the Bank Rate.
• New Equilibrium: The intersection of the AD2 and AS curves represents the new equilibrium price level (P2) and real output (Y2).

Explanation of Changes:

• AD Curve Shift: A decrease in the Bank Rate increases borrowing and spending by consumers and businesses, leading to an increase in aggregate demand. This shifts the AD curve to the right (from AD1 to AD2).
• Equilibrium Changes: The shift in the AD curve leads to a new equilibrium point where the AD2 curve intersects the AS curve. This results in a higher equilibrium price level (P2) and a higher equilibrium real output (Y2).
• Impact on Output: The increase in real output (Y2) reflects the increased economic activity stimulated by the lower interest rates.
• Impact on Price Level: The increase in the price level (P2) reflects the inflationary pressure caused by the increased aggregate demand.

Conclusion: A decrease in the Bank Rate shifts the AD curve to the right, leading to a higher equilibrium price level and a higher equilibrium real output. However, this can also lead to inflation. The magnitude of the change in output and price level depends on the responsiveness of the AD and AS curves.