Question

4. Describe the impact of a European Central Bank's decision to reduce the amount of money on macroeconomic balance for the short term. Describe the adaptation process that turns the economy into full employment

Answer 1

Ans. When the European Central Bank uses a contractionary monetary policy i.e. decreasing the money supply, there is a situation of excess money demand in the economy at a given level of money demand. This leads to an increase in interest rate causing cost of borrowing to increase which leads to a decrease in private investment  and consumption spending. This increase in interest rate also causes net capital inflow to increase which increases the demand for Euro causing it to appreciate which makes the imports cheap and exports expensive causing net exports to decrease. This decrease in private investment, consumption and net exports leads to a decrease in aggregate demand for goods and services shifting aggregate demand curve to the left from AD to AD' which leads to a situation of excess supply in the market causing prices to fall from P to P' and equilibrium output from Y to Y'.

In long run, due to decreased prices inputs become cheaper and production units revise their expectation of inflation downwards which leads to an increase in aggregate supply shifting aggregate supply curve to the right from AS to AS' . This decreases the price further to P" and output moves back to the full employment level of output Y.

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