Question

5. Why do central banks and the Federal Reserve carry out contractive monetary policies in periods of inflation?

a. Briefly explain the quantity theory of money

b. Explain why contractive monetary policies are carried out, using the quantity theory of money as the basis for your explanation.

c. Explain what instruments a central bank or the Federal Reserve has to carry out contractive monetary policies, and what it has to do (raise or lower, buy or sell) in each case.

Answer 1

Ans :5) The Federal Reserve carries out contractionary Monetary Policy in case of inflation. During inflationary periods , too much money chases few goods i.e. the aggregate demand is very high as compared to aggregate supply which increases the price levels causing inflation . It is a result of high purchasing power of consumers or too much money in the hands of the buyers . It further disrupts the equilibrium in an economy so the Federal Reserve follows Contractionary money policy which means that it decides to decrease the money supply in the economy . Through this policy , the excess money in the hands of the buyers is taken away or in other words it aims to decrease the purchasing power of the buyers through various tools. Consequently , the Aggregate demand also falls due to decline in the purchasing power . Hence the excess demand declines and the economy attains equilibrium.

a) Quantity theory of Money : It states that money supply is directly proportional to the prices of goods and services . It means that other things remaining constant , if the supply of money increases in the economy the prices/output/GDP will also rise with same proportion. If there is decrease in the money supply , there will be decrease in the prices by equal magnitude.

The equation used to explain this theory is : MV=PT

M= money supply

V = velocity of money

P = prices

T = TOTAL VOLUME OF GOODS TRANSACTED .

Note: Sometimes the equation is also used in the form : MV=PQ

where Q = output .

b) Contractive Monetary Policies are also carried on the basis of qty theory of money . The mentioned theory helps us to ascertain the amount of money flowing(M) in the economy with respect to the country's GDP(PQ or PT) or prices . If the amount of money in the economy increases , it means the prices are also increasing leading to inlflation(which is rise in general price levels) . The increased money supply also increases the purchasing power and hence the Aggregate demand. It creates an inflationary pressure in the economy . In order to correct the situation we make use of the same relatuonship as in qty theory of money. The increased flow must be decreased to restore equilibrium . The decrease in money supply will also decrease the prices and ease the inflationary pressure . The action of decreasing money supply is called contractionary Monetary Policy. Hence this policy makes the qty theory of money its basis.

c) Instruments used by the Central Bank to carry out Contractionary Monetary Policy -:

i) Interest rates : The interest rates such as discount rate, and federal funds rate are increased . It makes the cost of borrowing high and hence decreases the money flow in the economy.

ii) Reserve Requirements : Increase the reserve requirements of the banks . This decreases the amount of money available for loans and helps in controlling money supply in the economy .

iii) Open Market Operation: It refers to buying and selling of govt securities in open market . The central bank sells the govt securities in the open market. It absorbs the excess money from the economy .