Chapter 14: Problem 21

How do the expansionary and contractionary monetary policy affect the quantity of money?

Short Answer

Expert verified

In conclusion, expansionary and contractionary monetary policies have opposite effects on the quantity of money in an economy. Expansionary policy actions, like lowering interest rates and purchasing government bonds, increase the money supply. Conversely, contractionary policy actions, such as raising interest rates and selling government bonds, decrease the money supply.

Step by step solution

Understand Expansionary Monetary Policy

Expansionary monetary policy is a set of actions taken by a central bank, such as lowering interest rates or purchasing government bonds, to increase the money supply in an economy. The purpose of this policy is often to stimulate economic growth, lower unemployment rates, and avoid deflation.

Understand Contractionary Monetary Policy

Contractionary Monetary Policy is a set of actions taken by a central bank, such as raising interest rates or selling government bonds, to decrease the money supply in an economy. The purpose of this policy is to slow down inflation, reduce asset bubbles, and maintain financial stability.

Analyze the Effects of Expansionary Monetary Policy on Money Quantity

When a central bank implements expansionary monetary policies, it causes an increase in the money supply. This can occur through several channels, such as: 1. Lowering interest rates: When interest rates decrease, it becomes cheaper for banks to borrow from the central bank. As a result, banks have more cash to lend to businesses and consumers, leading to increased borrowing and spending, and thus increasing the money supply. 2. Purchasing government bonds: By buying government bonds from the open market, the central bank increases the liquidity of financial institutions. This additional liquidity enables banks to create more loans, which then increases the money supply.

Analyze the Effects of Contractionary Monetary Policy on Money Quantity

When a central bank implements contractionary monetary policies, it causes a decrease in the money supply. This can occur through several channels, such as: 1. Raising interest rates: When interest rates increase, it becomes more expensive for banks to borrow from the central bank. As a result, banks have less cash to lend to businesses and consumers, leading to decreased borrowing and spending, and thus reducing the money supply. 2. Selling government bonds: By selling government bonds in the open market, the central bank removes liquidity from financial institutions. With less liquidity, banks create fewer loans, which then decreases the money supply.

Conclusion

In conclusion, expansionary and contractionary monetary policies have opposite effects on the quantity of money in an economy. Expansionary policy actions, such as lowering interest rates and purchasing government bonds, increase the money supply. On the other hand, contractionary policy actions, such as raising interest rates and selling government bonds, decrease the money supply.