Monetary Policy Example

Suppose, for example, that the Federal Reserve wants to stimulate aggregate demand by increasing the money supply. Increasing the money supply from, say 500 billion dollars to 1000 billion dollars would lead to a lower interest rate ceteris paribus, and that in turn would lead to more investment, which would lead by a multiplier effect to increased real income. But "ceteris paribus" here means, among other things, that the price level is given. The higher the price level, the less the real purchasing power of either 500 or 1000 billion dollars would be, and so the higher the interest rate, lower the investment and real GDP in each case. In other words, each money supply defines a Pigou Curve, but the Pigou Curve corresponding to 1000 billion is to the right of the one for 500 billion, as shown in the following diagram:

Figure 6: Changing Pigou Curve

Here again, the diagram doesn't show us much, because so much is going on behind the scenes. So, once again, we suggest s look at the numbers in detail. Take a second look at the table with the data for M=500, and see how interest, investment and equilibrium real income change as the price level changes, defining the lower Pigou Curve. Then compare the table for M=1000, and see how the higher nominal money supply leads to a greater aggregate demand at any price level. If you are interested in the algebraic details of how these examples were constructed, they are in a footnote.

Why is it called the Pigou Curve?