Question

QUESTION 4
a. Explain how the Central bank can change the money supply? (3 marks)
b. Using appropriate diagrams, critically analyse the short run and long run effect of a contractionary monetary policy on aggregate demand. (7 marks)

Answer 1

Monetary policy by the central monetary authority (Federal Reserve in the US) is conducted to influence, target or stimulating the aggregate spending through the channel of credit creation and liquidity. The tools are quantitative easing, open market operations, reserve requirements and discount rate. All of them are aimed at either targeting interest rate, or inflation rate. a) The discount rate The discount rate is the interest rate the Fed charges on loans that it makes to banks. If the Fed wants to lower the money supply, it increases the discount rate. Higher the discount rate, less encouragement will the banks get to borrow from the Fed. When the borrowing is reduced, the Fed, the amount of loan granted is reduced in tandem and so the money supply reduced. This shifts AD to the left, reducing it, causing output to decline and interest rate to increase. b) Reserve requirements Higher reserve requirements would reduce the bank profits as it limit the amount of loans they can grant. It is just like a tax. The lending capacity will be reduced and so the money supply will fall. This shifts AD to the left, reducing it, causing output to decline and interest rate to increase. c) Open market operations Open market operations is the process of the buying and selling of government securities by the Fed in the open market. When the Fed has an aim to reduce the money supply, it enters the money market and sells government securities. Currency in circulation, deposits all are reduced and through the multiplier effect, money supply is reduced. This shifts AD to the left, reducing it, causing output to decline and interest rate to increase.

Short run impact Suppose central bank reduces the money supply. This is a contractionary monetary policy and is aimed at reducing the rate of interest which increases the access to credit by economic agents. A decreased money supply results in a increasing the rate of interest which depresses the spending so aggregate demand so AD shifts to the left till the new and a lower equilibrium is achieved. Both the level of employment and real GDP are reduced and unemployment is higher. Prices are decreased during the transition. Long run impact Since this new equilibrium has a lower price and an output gap, this is called an recessionary gap. As price has decreased, real wage starts increasing. Workers experience their real wage rate increasing and so the market fails to restore equilibrium. Firms then revise nominal wage (now lower to match the price fall) contracts with falling prices. Firms will hire more labor when wage contracts are revised and price expectations are changed. Hence the economy experiences a rightward shift of the AS curve where a new equilibrium is determined. Production is increased but price has decreased further. This decreases money demand and interest is decreased back to its original level.

Prica LRAS ZAS A'S DOR AD A'D' Yi Yf