Question

The economy is currently experiencing an economic boom with low unemployment and high output.

The Federal Reserve could conduct contractionary monetary policy to restore the economy to its natural rate of output.

1. Draw and upload a graph of the money market to illustrate the effect of an open-market operation that would be consistent with contractionary monetary policy.

2. Draw and upload a graph of the Aggregate Demand and Aggregate Supply model to illustrate the impact of the contractionary monetary policy in returning the economy to the natural level of output.

Be sure to carefully label all components of your graph.

3. Briefly explain how the contractionary monetary policy works to have the effect that you have shown in the Aggregate Demand and Aggregate Supply model above.

Answer 1

1. In the money market, when the money supply is reduced through contractionary monetary policy by the central bank, the money supply curve shifts backwards and intersect the money demand curve at higher interest rate and lesser quantity of money.

2. The contractionary monetary policy will shift the AD curve backwards and it will intersect the AS curve at lesser level of GDP.

3. In the contractionary monetary policy, the central banks reduces the money supply to increse the interest rates in the economy. The rise in interest rates leads to lesser credit creation in the economy. The investment and consumption component of aggregate demand declines. Due to this, aggregate demand curve shifts backwards and the real GDP is reduced through contractionary monetary policy.