Question

Step 1: The first part of the instructions/rubric is to discuss a reason why contractionary policy should be used. What kind of things can happen in the economy to cause the Fed to need to use contractionary monetary policy? What kind of things would they look for to let them know that the economy is growing too fast and needs to slow down?

Step 2: The next part of the instructions is to explain how each of the three tools of the Fed (open market operations, changing interest rates, and changing reserve requirements) can be used to contract the money supply. It’s important here that when you are explaining them, you are specifically talking about how to use them to contract the money supply, not just how they could affect it. For example, for interest rates, you can’t just say “we can raise or lower them.” You need to explain which of those actually is contractionary.

Step 3: The last part has you explain why you choose the tool you chose, and why the other two options weren’t chosen.

If it would help make sure you are covering everything, you can break this down into a sort of checklist:

1. What would be happening in the economy to cause the Fed to believe that contractionary monetary policy is needed?

2. How can the Fed use Open Market Operations to contract the money supply?

3. How can the Fed use changing reserve requirements to contract the money supply?

4. How can the Fed use changing interest rates to contract the money supply?

5. Which tool have you chosen, why is that the best option, and why are the other two options worse than the one you chose?

Answer 1

1. If the level of real GDP in the economy is more than potential level of real GDP, economic growth rate is increasing at more than the productive capacity of the economy and the price level in the economy is above the target zone set by the Central Bank, then there is need for the Central Bank to follow contractionary monetary policy which will help in reducing aggregate demand by reducing money supply and thus reducing economic growth to the level which is equal to the productive capcaity of the economy.

2. The Fed should sell government securities in the open market to reduce the level of money supply in the economy.

3. To contract money supply, the Fed should increase its reserve requirements so that banks lend less money and this reduces money supply which in turn reduces aggregate demand in the economy.

4. The Fed should increase its interest rate like discount rate etc to contract the level of money supply in the economy.

5. It is better to use open market operations in the short run because transmission mechanism is strong and implementation lag is also small. On the other hand, other two options depend on the transmission mechanism ands also ability of commercial banks to transmit the rate cuts and interest rate sensitiity of investment demand in the economy.