Put the pieces together. The central bank changes interest rates; interest rates change spending; spending moves aggregate demand.
Key idea
Expansionary monetary policy: buy bonds (or cut administered rates) → interest rates fall → investment and other interest-sensitive spending rise → AD shifts right → real GDP and the price level rise, unemployment falls. Contractionary policy runs the chain in reverse.
Why it works
Lower interest rates make it cheaper to borrow for a new factory, a home or a car, so firms and households spend more at every price level: AD shifts right. Only two links in the chain are shifts: the money supply in the money market, and AD in the AD–AS model. The others are movements along curves: along money demand to the new rate, and along investment demand to a new level of investment.
Worked examples
Worked example: Ordering the steps
The Fed sells bonds. Put the effects in order.
- Reserves and the money supply fall.
- Interest rates rise.
- Investment and interest-sensitive consumption fall; AD shifts left.
- Real GDP and the price level fall; unemployment rises.
Answer: Money supply ↓ → interest rates ↑ → investment ↓ → AD ↓ → output and prices ↓
Worked example: How big a shift?
Investment demand is $I = 400 - 20i$ (billions, $i$ in percent). The Fed lowers the rate from 6% to 4%. With MPC 0.8, how far does AD shift?
- $I$ at 6%: $400 - 120 = 280$. At 4%: $400 - 80 = 320$. Investment rises 40.
- Multiplier $= 5$, so AD shifts right by $5 \times 40 = 200$ billion dollars at each price level.
Answer: \$200 billion to the right
The Fed steers a very short-term rate. Longer-term rates, like those on mortgages, are set in markets and depend on expected future rates, inflation and risk; they usually follow the Fed's moves, but not one for one. Policy also takes time: its effects on spending can take many months to show up.
Common mistake
Linking the steps in the wrong order, or thinking the central bank directly sets every interest rate, mortgage rates included. Check: start in the money market and end with AD; the Fed sets a short-term policy rate, and other rates respond.
See it with real data: the federal funds rate and the 10-year Treasury yield on the Economic Data page. They move together, but not step for step.