Question

Describe how a decrease in money supply on the monetary side of the economy is transmitted to the real side. In particular, emphasize what happens on the (i) money market, (ii) credit market, and (iii) goods & services market. Will GDP eventually be higher or lower?       (6 sentences max.)

Answer 1

Consider that Fed pursues contractionary monetary policy (decrease in money supply on the monetary side of the economy) when it considers inflation a threat.

Suppose, for example, that the economy faces an inflationary gap (Y1 > Full Employment level of Output YP); the aggregate demand (AD1) and short-run aggregate supply curves (SRAS1) intersect to the right of the long-run aggregate supply curve (LRAS), as shown in Panel (a)

In Panel (a), the economy has an inflationary gap Y1 − YP.

A contractionary monetary policy could seek to close this gap by shifting the aggregate demand curve to AD2. In Panel (b), the Fed sells bonds, shifting the supply curve for bonds to S2 and lowering the price of bonds to Pb 2. The lower price of bonds means a higher interest rate, r2, as shown in Panel (c).

In the money market, the interest rate would increase as the money supply is lowered.

The banks have to maintain higher reserves with the Fed. The loan creating capacity of the bank reduces.

In the credit market, given the demand for loans, the supply of loans is reduced due to reduction in loan creating capacity of the banks. Thus, interest rate would increase.

In goods & service market, there would be reduction in demand for investments as the cost of borrowing increases with the increase in the interest rate in the credit market.

The higher interest rate also increases the demand for and decreases the supply of dollars, raising the exchange rate to E2 in Panel (d), which will increase net exports. The decreases in investment and net exports are responsible for decreasing aggregate demand in Panel (a).

To carry out a contractionary policy, the Fed sells bonds. In the bond market, shown in Panel (b), the supply curve shifts to the right, lowering the price of bonds and increasing the interest rate.

In the money market, shown in Panel (c), the Fed’s bond sales reduce the money supply and raise the interest rate.

The higher interest rate reduces investment in the goods & services market.

The higher interest rate also induces a greater demand for dollars as foreigners seek to take advantage of higher interest rates in the United States.

The supply of dollars falls; people in the United States are less likely to purchase foreign interest-earning assets now that U.S. assets are paying a higher rate.

These changes boost the exchange rate, as shown in Panel (d), which reduces exports and increases imports and thus causes net exports to fall in the goods & services market.

The contractionary monetary policy thus shifts aggregate demand to the left, by an amount equal to the multiplier times the combined initial changes in investment and net exports, as shown in Panel (a).

Thus, GDP would eventually be lowered due to contractionary monetary policy that calls for decrease in money supply on the monetary side of the economy.