Question

The Federal Reserve Bank announced that it was changing its policy from expansionary monetary policy to a more contradictory policy to prevent inflation from increasing as the economy recovers from the 2007-2009 recession. As a result, interest rates will rise. Was this a good move? Why or why not? Define monetary policy.

Answer 1

Monetary policy refers to a central bank's policy of controlling money supply. When the central bank wishes to increase money supply, it uses expansionary monetary polic and when it wishes to decrease money supply, it uses contractionary monetary policy.

Increase in interest rate caused by a contractionary monetary policy will lower the portion of consumption demand funded b borrowing, and will decrease investment demand. As a result, aggregate demand will decrease, lowering price level (and taming inflation). However, at the same time, real GDP (output) will fall as well, leading to higher unemployment.

The US economy is still on the path of recovery. Real GDP is growing at a slow pace and unemployment is still high since job addition is rising at a low pace. In this situation, dampening of aggregate demand that will lower output will further add to unemployment. Therefore the contractionary monetary policy is most likely wrongly timed, being implemented before the economy has completely come out from recession and is on a strong growth path.