Question

Draw graphs (4) to show contractionary monetary policy (policy to reduce GDP), and describe what happens in each graph.

Answer 1

Contractionary monetary policy emplies reducing the money supply in the economy.A reduction in money supply shifts the LM curve leftwards thus leading to a rise in interest rates.A rise in interest rates in turn reduces the level of investment in the economy thus shifting the AD curve leftwards resulting in a decrease in overall spending level as investment is one of the components of spending.Thus as a result of this the overall output level or real GDP level and overall price in the economy falls.

In the diagram below the the decline in money supply shifts the LM curve from LM to LM^' resulting in a rise in interest rates.This leads to a fall in investment spending thus causing the AD to shift leftwards from AD to AD^' resulting in a lower level of equilibrium real GDP and price level.