Question

Question 2 (a) Elaborate on the process taken by the central bank when conducting a contractionary monetary policy. [15 marks] (b) Based on your answer above, select an economic problem where a contractionary monetary policy would help eradicate and explain what happens. [13 marks]

Answer 1

Contractionary monetary policy is when a central bank uses its monetary policy tools to fight inflation. Since inflation is a sign of an overheated economy, the bank must slow economic growth. It will raise interest rates to make lending more expensive. It is also called restrictive monetary policy.

The Fed measures inflation using the core inflation rate. Core inflation is year-over-year price increases minus volatile food and oil prices. The Consumer Price Index is the inflation indicator most familiar to the public. The Fed prefers the Personal Consumption Expenditures Price Index. It uses formulas that smooth out more volatility than the CPI does.

If the PCE Index for core inflation rises much above 2 percent, then the Fed implements contractionary monetary policy.

Implementation:-
The Fed raises interest rates by increasing the target for the fed funds rate. That increases the rate that banks charge each other to borrow funds to meet the reserve requirement. The Federal Reserve requires banks to have a specific reserve on hand each night. For most banks, that's 10 percent of their total deposits. Without this requirement, banks would lend out every single every dollar people deposited. They wouldn't have enough cash in reserve to cover operating expenses if any of the loans defaulted.

Raising the fed funds rate is contractionary because it decreases the money supply. Banks charge higher interest rates on their loans to compensate for the higher fed funds rate. Businesses borrow less, don't expand as much and hire fewer workers. That reduces demand. As people shop less, firms slash prices. Falling prices put an end to inflation.

The Fed also uses open market operations. That's when the Fed buys or sells its holdings of U.S. Treasury notes. To implement contractionary policy, the Fed sells Treasurys to one of its member banks. The bank must pay the Fed for the Treasurys on its books reduces. As a result, banks have less money available to lend. With less money to lend, they charge a higher interest rate. It has the same effect as raising the fed funds rate.

b). Higher interest rates make loans more expensive. As a result, people are less likely to buy houses, autos, and furniture. Businesses can't afford to expand. The economy slows. If not exercised with care, contractionary policy can push the economy into a recession.