How Monetary Policy Affects the Economy - Key Concept

How does monetary policy affect the economy? Let’s look at the demand and supply of money in the economy. The money supply curve is vertical because the amount of money is determined by the Fed independently. If the Fed implements an expansionary monetary policy, it buys bonds. This increases the amount of money in the economy and shifts the money supply curve to the right.Banking reserves increase and banks make more loans. The supply of loanable funds curve shifts to the right. The increased supply of funds in the economy places downward pressure on real interest rates.As the real interest rate falls from R1 to R2, lower interest rates stimulate consumption, investing and net exports. The aggregate demand curve shifts right from AD1 to AD2. Production increases from Y1 to Y2 and prices increase.