Question

explain the meaning of monetary policy. Differentiate between contractionary and expansionary monetary policy.

Answer 1

The term "monetary policy" refers to what the Federal Reserve, the nation's central bank, does to influence the amount of money and credit in the U.S. economy.What happens to money and credit affects interest rates (the cost of credit) and the performance of the U.S. economy.Central Bank can change the monetary policy in accordance to the changing economic conditions.

• Expansionary Monetary Policy aims at increasing the money supply in the economy whereas Contractionary Monetary Policy aims at reducing the money supply in the ecomomy.
• While adopting Expansionary Monetary Policy Fed reduces the interst rate. With the reduction in interst rate the cost of borrowing becomes cheap. As a result firms can invest more and consumers can demand more thus aggregate demand and spending is increased. But In case of Contractionary monetary policy the interest rates are increased by the Fed. As a result borrowing becomes expensive for both firms and consumers. This result in reduction in aggregate demand and spending.
• On international front lower interest rates reduce the value of the Dollar, making exports cheaper and increase export demand, in case of Expansionary monetary policy. But when Contractionary monetary policy is followed higher interest rates increase the value of dollar, making exports costlier and thus reducing export demand.
• Expansionary Monetary Policy is followed during the time of recession and unemployment. The basic purpose of it is to pump money into the stagnant economy by boosting aggregate demand and spending. But Contractionary monetary policy is followed at times of inflation.The basic motive is to erode the excess purchasing power from the economy by reducing aggregate demand and spending.
• Some tools of Expansionary monetary policy include decreasing the discount rate, purchasing government securities and reducing the reserve ratio. All of these options have the same purpose to expand the supply of currency or money supply for the country. On the other hand Contractionary monetary policy includes selling U.S. Treasury securities in the open market (that would be what we would call open market operations), raising the reserve requirements snd increasing the discount rate. The purpose is to reduce the excess money supply from the economy.

To conclude both Expansionary and Contractionary monetary policies are opposite of each other. Expansionary monetary policy aims at loosening the money supply in the economy inorder to stimulate the economy whereas Contractionary monetary policy aims at tightening the money supply in the economy to absorb the excess money supply from the economy.