Question

macroeconomics

Explain the purpose of a contractionary monetary policy. Using relevant diagrams, explain the transmission mechanism of Open Market Operations when the central bank carries out a contractionary monetary policy.

Answer 1

Contractionary monetary policy is used when economy is in expansion with higher aggregate demand causing high real GDP growth along with high inflation rate. To tame inflation, central bank reduces aggregate demand, by lowering money supply using following tools:

1. By open market sale of government securities

2. By raising required reserve ratio ir

3. By raising discount rate.

In following graph, MD0 and MS0 are initial money demand and supply curves, intersecting at point A with initial interest rate r0 and quantity of money M0. Decrease in money supply causes MS0 to shift left to MS1, which intersects MD0 at point B with higher interest rate r1 and lower quantity of money M1.

Higher interest rate decreases investment, which decreases aggregate demand. AD shifts left, decreasing price level (inflation) and lowering real GDP.

In following graph, initial equilibrium is at point A where AD0 (aggregate demand) and SRAS0 (short-run aggregate supply) curves intersect with initial equilibrium price level P0 and initial equilibrium real GDP Y0. Lower investment causes AD0 to shift leftward to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.