Question

Define and contrast contractionary monetary policy and expansionary monetary policy and their respective economic outcomes (include changes in equilibrium interest rates). Explain what happens if the affects of either of these policies goes too far.

Answer 1

The extent to use expansionary monetary policy: If the central bank keeps raising the money supply, the interest rates comes to its lower level, then the economy would be in a situation of liquidity trap. In this the LM curve would be horizontal and the interest rates are at the lowest level. A further monetary expansion would not increase the output. in this case, the fiscal expansion can increase the output. Also, excess money supply can create a situation of hyperinflation in the country.

The extent to use contractionary monetary policy: If the central bank keeps decreasing the money supply, it raises the interest rates to higher level, which means the LM curve after a period of time becomes vertical and then output cannot be increased further. Only fiscal policy would be effective in that case. With monetary expansion, the output decreases .