Graph walkthrough · Macro · Aggregate demand and aggregate supply
The central bank cools an overheating economy
With inflation rising, the central bank raises its policy rate.
Step 1 of 3 · Inside the boom
The economy is overheating. The horizontal axis is real GDP and the vertical axis is the price level. AD and SRAS cross at E₀, to the right of LRAS: output is above potential and prices are climbing. The dashed line shows where aggregate demand stood before the boom.
The chain in words
Step 1
Inside the boom
The economy is overheating. The horizontal axis is real GDP and the vertical axis is the price level. AD and SRAS cross at E₀, to the right of LRAS: output is above potential and prices are climbing. The dashed line shows where aggregate demand stood before the boom.
Step 2
Aggregate demand shifts left
The rate rise makes mortgages, car loans and business borrowing dearer. Households and firms cut spending at every price level, so aggregate demand shifts left. Firms trim output and hold prices.
Step 3
Back on LRAS
The economy moves down SRAS to E₁ on LRAS. Output is back at potential and the price level has fallen from the peak. The central bank closed the inflationary gap before wages and costs could lock in the higher prices.
Takeaway. Contractionary monetary policy shifts AD left and closes an inflationary gap by lowering the price level and output.
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Lesson: Monetary Policy Transmission