Question

7. Draw graphs (4) to show contractionary monetary policy (policy to reduce GDP), and describe what happens in each graph.

Answer 1

Contractionary monetary policy is most oftenly used to fight inflation.Under this policy, the money siply in the economy is reduced (either by open market sale or increase in required reserve ratio etc.). As a resilt, the LM curve shifts to the left, intersecting the IS curve at the new higher equilibrium interest rate and lower GDP.

A rise in interest rates result in a fall in Investment (I), which shifts the Aggregate demand (AD) curve leftwards. Thus the exonomy witnesses a fall in GDP and a fall in price level, producing the desired resilt of combating inflation.