Question

Consider a monetary contraction in an economy operating under flexible exchange rates.

Discuss the effects on consumption, investment and net exports. Explanation in words as well as use of graphs are required

Answer 1

Ans.)

Monetary contraction refers to the decrease in the money supply in the economy and it is a type of monetary policy conducted by the central bank of a country.

If there is a monetary contraction in an economythe money supply decreases and the LM curve shifts towards left leading to the increase in interest rate. As the interest in the home country increases relative to the same in the foreign country , the foreigners start investing in the home country and the supply of foreign funds increases leading to appreciation of home currency.
Appreciation of home currency means that it requires less units of home currency to buy one unit of foreign currency.
Effect on Consumption :
As we see on the IS-LM curve that the output declines and interest rate increases when the LM curve shifts from LM to LM', the income of individuals decreases. Also people take less loans from the banks due to the increase in interest rate.The change in income and interest rate leads to the decrease in consumption.
Effect on investment:
As the interest rate has increased , the firms do not undertake many investment projects due to non viablity of project at high cost of bank loans.
There is cut down on investments.
Effect on net exports:
As the home currency has appreciated, the foreign goods become cheaper and thus the demand for imports increases which leads to the decline in net exports.Also the home country goods become costlier due to the appreciation of home currency and demand for exports decreases.

The below IS-LM diagram shows the shift in LM curve.

The AD-AS curve shows the shift in the AD curve towards left.