Question

Using words and graphs analyze the macroeconomic effects of contractionary monetary policy in the short run. Provide as much detail as possible.

Answer 1

Contractionary monetary policy lowers money supply, shifting money supply curve leftward, which increases interest rate and decreases quantity of money.

In following graph, MD0 and MS0 are initial money demand and supply curves intersecting at point A with initial interest rate r0 and quantity of money M0. As money supply falls, MS0 shifts left to MS1, intersecting MD0 at point B with higher interest rate r1 and lower quantity of money M1.

In IS-LM model, a fall in money supply shifts LM curve to left, increasing interest rate and decreasing output. In following graph, IS0 and LM0 are initial IS and LM curves intersecting at point A with initial interest rate r0 and output Y0. As money supply falls, LM0 shifts left to LM1, intersecting IS0 at point B with higher interest rate r1 and lower output Y1.

In AD-AS model, higher interest rate lowers investment, reducing aggregate demand and shifting AD curve to left, reducing both price level and real GDP. In following graph, AD0 and SRAS0 are initial aggregate demand and short run aggregate supply curves intersecting at point A with initial price level P0 and real GDP Y0. As money supply falls, AD0 shifts left to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real GDP Y1.