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how would contractionary monetary policy affects the price level, the real interest rate and the output...

how would contractionary monetary policy affects the price level, the real interest rate and the output in the short term and the long term

show the short term and long term equilibrium on the is-lm graph

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Answer #1

A contractionary monetary policy decreases money supply and so real interest rate rises. This reduces investment spending and so aggregate demand decreases in goods market. Output falls, price level falls and LM curve shifts leftwards in the short run (A to B)

In the long run, as output has fallen, demand for money is reduced. This shifts the money demand down and real interest rate reaches its original equilibrium level. At the same time, investment rises and so output rises as well. LM curve shifts to the right and thus, both the real interest rate and output level reach their original equilibrium level (B to A)

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