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Chapter 26: Problem 4

A student says the following: "I understand why the Fed uses expansionary policy, but I don't understand why it would ever use contractionary policy. Why would the government ever want the economy to contract?" Briefly answer the student's question.

Short Answer

Expert verified
A contractionary policy is used by the Federal Reserve, not to make the economy contract, but to slow down its growth when it overheats. An overheated economy can lead to high inflation, which erodes the value of money. By raising interest rates and decreasing the money supply, the Federal Reserve manages to control inflation and maintain economic stability.

Step by step solution

01

Understanding the role of the Federal Reserve

The Federal Reserve, often referred to as the Fed, is the central bank of the United States. They have the responsibility for monetary policy, which is the management of the money supply and interest rates aimed to promote economic growth and stability. Their primary goal is to keep unemployment low, prices stable, and moderate long-term interest rates.
02

Recognizing an overheating economy

The economy may overheat when it grows too fast, triggering high demand for goods and services. This rapid growth often leads to an increase in the level of prices, known as inflation. Inflation can erode the value of money as prices for goods and services become more expensive.
03

Explaining contractionary policy

In the scenario when the economy is overheating, which may lead to high inflation, the Federal Reserve uses a contractionary policy. This policy includes raising interest rates and decreasing the money supply. The aim here is not to make the economy contract but to slow down its growth to a sustainable level in order to maintain economic stability. Reducing the pace of economic growth can help to lower inflation rates.

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Most popular questions from this chapter

What is a monetary rule, as opposed to a monetary policy? What monetary rule would Milton Friedman have liked the Fed to follow? Why has support for a monetary rule of the kind Friedman advocated declined since \(1980 ?\)

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