Contractionary Monetary Policy (CMP)

Question 1

Define contractionary monetary policy

Answer 1

• reduce AD
• changing short-term interest rates
• suitable if cause of inflation in due to rise in C and I

Question 2

Examples of CMP

Answer 2

• reducing money supply
• increase in i/r (cost of borrowing increase, I and C decrease, AD leftward shift)
• more stringent requirements on banks’ lending activities

Question 3

Strengths of CMP

Answer 3

1. Relatively quick implementation
2. Central Bank Independence
3. Ability to adjust interest rates incrementally

Question 4

Constraints of CMP

Answer 4

1. Responsiveness of firms and households to rise in i/r
2. Conflict with other macroeconomic goals
3. Time Lags
4. Political Acceptability

Question 5

Relatively quick implementation (+ve)

Answer 5

• quicker than fiscal policy

- dont need to undergo political process (cumbersome and time consuming)

Question 6

Central Bank Independence (+ve)

Answer 6

• independence frm gov
• can make pragmatic decisions that are best for economy in long run
• greater freedom in pursuing policies that may be politically unpopular (e.g. higher i/r makes borrowing more costly in times of high inflation)

Question 7

Ability to adjust i/r incrementally

Answer 7

• makes policy btr suited to ‘fine-tuning’ economy
• can raise i/r a little at a time to lower inflation rate
• e.g. increasing i/r by 50 basis pts means increase by 0.5%
• has limitations, no such thing as fully fined tuned economy

Question 8

Responsiveness of firms and households (-ve)

Answer 8

• effectiveness of policy depends on responsiveness of firms and household
• desired effect: reduce in C and I (CMP effective)
• undesired effect: lvl of AD high relative to AS (dd pull inflation), increased profits may off set extra cost of borrowing, firms still continue to borrow to expand business
• undesired effect: households optimistic abt economy, future incomes, won’t reduce C despite higher i/r

Question 9

Conflict with macroeconomic goals (-ve)

Answer 9

• may lead to conflict with economic growth and low unNt

- fall in AD lead to fall in GDP, rise in unNt as production falls in economy

Question 10

Time lags (-ve)

Answer 10

• recognition lag, decision-making lag, implementation lag and response lag
• economists estimate that it takes as long as 18 months for change in i/r to be felt in economy
• economy may have turned arnd due to weakening original cause of inflation/problem
• full impact of delayed effect can cause economy to face new problem of unNt and not inflation

Question 11

Political acceptability (-ve)

Answer 11

• some are able to cope with changes but others aren’t
• e.g. rise in i/r affect poor more than rich
• cos poor are likely to be net borrowers (borrow more than save)
• policy of raising i/r politically unpopular, esp if many low-income families in country