Question

6. Trace the impact of a contractionary monetary policy on each one of the following: a) bond prices, b) interest rates, c) investment, d)the exchange rate, e) net exports, f) real GDP, and g) the price level. To the Tutor: Please be clear and explanatory. Will be appreciated. Thank you. Note: I already have this question answered but unfortunately not satisfied with the answer at all, that is why I am posting this again, hopefully get a clear, explanatory and better writing. Thanks again.

Answer 1

Contractionary monetary policy means that the government has reduced the supply of money in the economy through the Central Bank.

When there is reduction in the money supply, then at the initial level of equilibrium output and income, the interest rate increases. Interest rate increases to maintain equilibrium in the money market. In other words, reduction in the money supply reduces the amount of money available to the public for transaction purpose. So, they start to draw money out of their speculative balances. As a result, the interest rate will rise to maintain equilibrium in the money market.

Increase in the interest rate will be accompanied by reduction in the prices of bonds. This is because the Central Bank reduces the money supply through open market operations by selling government bonds. If the Central Bank want people to buy the bonds then it has to reduce their prices and increase their yield (interest rate). On the other side, to create incentive for the people to not to withdraw money for transaction purposes, bond prices must be reduced in the money market.

Increase in the interest rate will reduce investment spending. This is because increase in interest rate will raise the cost of borrowing for the businesses.

Increase in the interest rate will attract foreign financial flows like foreign institutional investors, who look for higher interest rate for investment. As foreign financial flows increases in the economy there will be pressure on the exchange rate to appreciate. This will happen because foreign investors need domestic currency for investment. As a result, demand for the domestic currency will increase while the supply of foreign currency will increase. This will cause the exchange rate to appreciate.

Appreciation of the exchange rate will make imports cheaper while exports expensive. As a result, net exports will decline.

Decrease in the money supply will cause the aggregate demand (AD) curve to shift backward to the left. This will cause the price to fall. In addition to decline in the price the real gross domestic product (GDP) will also fall due to reduced demand in the economy.