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What Effects Does Monetary Policy Have?

Expansionary Monetary Policy vs. Contractionary Monetary Policy


Contractionary Monetary Policy

As you can probably imagine, the effects of a contractionary monetary policy are precisely the opposite of an expansionary monetary policy. In the United States, when the Federal Open Market Committee wishes to decrease the money supply, it can do a combination of three things:
  1. Sell securities on the open market, known as Open Market Operations
  2. Raise the Federal Discount Rate
  3. Raise Reserve Requirements
These cause interest rates to rise, either directly or through the increase in the supply of bonds on the open market through sales by the Fed or by banks. This increase in supply of bonds reduces the price for bonds. These bonds will be bought up by foreign investors, so the demand for domestic currency will rise and the demand for foreign currency will fall. Thus the domestic currency will appreciate in value relative to the foreign currency. The higher exchange rate makes domestically produced goods more expensive in foreign markets and foreign good cheaper in the domestic market. Since this causes more foreign goods to be sold domestically and less domestic goods sold abroad, the balance of trade decreases. As well, higher interest rates cause the cost of financing capital projects to be higher, so capital investment will be reduced.


What We've Learned About Contractionary Monetary Policy:

  1. Contractionary monetary policy causes a decrease in bond prices and an increase in interest rates.
  2. Higher interest rates lead to lower levels of capital investment.
  3. The higher interest rates make domestic bonds more attractive, so the demand for domestic bonds rises and the demand for foreign bonds falls.
  4. The demand for domestic currency rises and the demand for foreign currency falls, causing an increase in the exchange rate. (The value of the domestic currency is now higher relative to foreign currencies)
  5. A higher exchange rate causes exports to decrease, imports to increase and the balance of trade to decrease.
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