Question

The economy is currently experiencing an economic boom with low unemployment and high output.

The Federal Reserve could conduct contractionary monetary policy to restore the economy to its natural rate of output.

Draw and upload a graph of the Aggregate Demand and Aggregate Supply model to illustrate the impact of the contractionary monetary policy in returning the economy to the natural level of output.

Be sure to carefully label all components of your graph.

Answer 1

The contactionary monetary policy will raise the interest rates in the economy. In other words, the cost of credit increases in the economy. This leads to lesser borrowings by the consumers and producers. Due to this, the consumption and investment portion of the aggregate demand declines as lesser credit is created by the commercial banks.

This shifts the aggregate demand backwards and due to this the level of real GDP reduces in the economy.