Question

Provide a real-life examples of when the Federal Reserve would lot to decrease our country’s money supply as opposed to an increase in our country’s money supply? If the Federal Reserve decides to contract our country’s money supply, can you explain why this would lead to higher interest rates and inflation?

Concise response!

Answer 1

The Federal Reserve opts for the contractionary monetary policy and decreases the money supply when the economy grows fast and there is a scope that aggregate demand surpasses the aggregate supply and create an inflationary gap in the economy. It causes the setting of higher inflation in the economy and the Federal Reserve opts for the decrease in the money supply. A real life example can be taken as the time of 2006 and first half of 2007 when the real estate was booming, pushing up the US economy and setting up high inflation rate. For example, it was over 4% in the year 2007. It led the Fed to act for the contractionary monetary policy, sell the treasury bills using OMO and suck the money out of the economy.
Since, the money supply comes down, then it leads to the less money available as a reserve and for the disbursement to the borrowers, the interest rate increases. The Federal Reserve also deliberately increases the Federal fund rate as indicator to raise the other interest rates. For example, it was over 5% in 2007 before the crisis took place. A higher interest rate is kept to discourage the households and firms alike and ugly buying habits are curbed. It helps in reducing the inflation and price stability is achieved.