Question

1. There is a contractionary monetary policy.

   1. Explain how the economy adjusts

   2. Use AA cure and DD curve to show the impact of this policy on the countries GNP and foreign exchange

Answer 1

Assume that the market is in long run equilibrium and there is a decrease in the money supply under the contractionary monetary policy. This is likely to increase the rate of interest in the market because the price level is considered to be fixed. The rate of interest is increased due to interest rate parity, there will be a currency appreciation in the short run. This immediate currency appreciation will make the domestically manufactured goods and services expensive and therefore the volume of exports decline and that of imports increase. Decline in will result in decreasing the equilibrium level of output. This is shown by the leftward shift of the AA curve where at the new equilibrium, Output (GNP) is reduced and currency is appreciated.

Exchange rate X---- -- AA AA Y2 Y1 Output