Monetary Policy in the AD-AS Model

The chain starts in the money market. The central bank buys bonds (an open market purchase), pushing the interest rate down, or sells bonds, pushing it up. A lower interest rate makes borrowing cheaper, so firms invest more in equipment and buildings, and households borrow more for big purchases. That extra spending is autonomous spending, and it gets amplified by the spending multiplier into a bigger shift in aggregate demand. AD shifts right, and in the short run both real output and the price level rise as the economy moves up the SRAS curve. A contractionary move runs the chain backward: sell bonds, interest rate up, investment down, AD shifts left, shrinking an inflationary gap by lowering both output and the price level.

Where the economy sits on SRAS decides how that AD shift splits between output and prices. If there is slack, below full employment, SRAS is fairly flat, so most of the AD increase shows up as higher real output with only a mild price rise. Near or at full employment, on LRAS, SRAS is steep, so the same AD shift mostly raises the price level instead, since firms cannot expand real production much further. This is why cutting rates when the economy is already at potential output mainly causes inflation months later rather than lasting growth.

This topic connects monetary policy directly to the AD-AS model you use for fiscal policy, so the two can be compared: both push AD, but monetary policy works through interest rates and investment rather than government spending or taxes.