so im really perplexed here… in monetary policy, real interest decrease when the fed injects money… this reduces the cost of capital and shifts the AD curve up… and vice versa… but then why do they say interest rates RISE as the economy is expanding… and fall when the economy is contracting… when AD curve goes up when real interest rates go down and AD curve goes down when real interest rates go up? Is it just the timing of the situation? Am I missing something here?
Let me try to remember this. As inflation rises, interest rates are increased in order to bring back GDP to full employment. Remember, it is one of the goals of the Fed (at least was) to maintain full employment (potential GDP). Inflation rises from an increase in demand when the economy is expanding. In an expanding economy, real GDP becomes above potential GDP. One of the ways to bring back GDP to potential GDP is done through a reduction of money supply. Money being supplied is reduced, so the cost of borrowing money increases since interest rates rise (less supply for a given demand), investment among other things decreases as a result, and GDP is now brought back to full employment. In a recession, to induce people to consume and make investments, the Fed will increase money supply, lowering interest rates, to bring real GDP back UP to potential GDP. Interest rates are low to induce growth in recessions; interest rates are higher in expanding economies to stem too much growth.
Take it this way Economy growing…Supply is still same but Demand Increases… Increase in Demand increases the IR (As supply is still same) to reduce utilization of existing supply… Fed Injects money…Demand is still same but supply increases…Increase in supply reduces the IR(As demand is still same) to enable more utilization of supply
i think you are confusing the AD curves with the money demand/supply curves: things to remember: 1. money supply is fixed at a particular time 2. For a given money supply and a certain interest rate, as the AD increases, the price level increases i.e. inflation increases and the real interest rate decreases. However as the AD increases, the demand for money increases (generally assuemed to be) and interest rate increases. So there are two things going here and its more subtle than it seems. Vice versa for the decreases in the AD posts by kartil and aliman are relevant…