Contractionary Monetary Policy

The central bank will generally pursue a contractionary monetary policy when it considers inflation a threat. Suppose, for example, that the economy faces an inflationary gap; the aggregate demand and short-run aggregate supply curves intersect to the right of the LRAS curve, as shown in Panel (a) of Figure A Contractionary Monetary Policy to Close an Inflationary Gap.

To carry out a contractionary policy, the CB sells bonds. In the bond market, shown in Panel (b) of Figure A Contractionary Monetary Policy to Close an Inflationary Gap, the supply curve shifts to the right, lowering the price of bonds and increasing the interest rate.

In the money market, shown in Panel (c), the CB’s bond sales reduce the money supply and raise the interest rate. The higher interest rate reduces investment. The higher interest rate also induces a greater demand for dollars as foreigners seek to take advantage of higher interest rates in the country. The supply of money falls; people in the countyr are less likely to purchase foreign interest-earning assets now that domestic assets are paying a higher rate.

These changes boost the exchange rate, as shown in Panel (d), which reduces exports and increases imports and thus causes net exports to fall. The contractionary monetary policy thus shifts aggregate demand to the left, by an amount equal to the multiplier times the combined initial changes in investment and net exports, as shown in Panel (a).

 

Figure A Contractionary Monetary Policy to Close an Inflationary Gap

 

Key concepts

· The central bank’s goal is to control inflation or the price stability. Providing that inflation is under control, the CB will act to close recessionary gaps

· Expansionary policy, such as a purchase of government bonds, tends to push bond prices up and interest rates down, increasing investment and aggregate demand.

· Contractionary policy, such as a sale of government bonds, pushes bond prices down, interest rates up, investment down, and aggregate demand shifts to the left.

Unit 6.2 Problems of Monetary Policy

Learning objectives

Explain the three kinds of lags that can influence the effectiveness of monetary policy.

Identify the macroeconomic targets at which the CB can aim in managing the economy, and discuss the difficulties inherent in using each of them as a target.

Discuss how each of the following influences a central bank’s ability to achieve its desired macroeconomic outcomes: political pressures and the degree of impact on the economy (including the situation of a liquidity trap).

Despite the apparent ease with which CB can conduct monetary policy, it still faces difficulties in its efforts to stabilize the economy. We examine some of the problems and uncertainties associated with monetary policy in this section.

Lags

Perhaps the greatest obstacle facing any central bank, is the problem of lags. It is easy enough to show a recessionary gap on a graph and then to show how monetary policy can shift aggregate demand and close the gap. In the real world, however, it may take several months before anyone even realizes that a particular macroeconomic problem is occurring. When monetary authorities become aware of a problem, they can act quickly to inject reserves into the system or to withdraw reserves from it. Once that is done, however, it may be a year or more before the action affects aggregate demand.

Only after policy makers recognize there is a problem can they take action to deal with it. The delay between the time at which a problem is recognized and the time at which a policy to deal with it is enacted is called the implementation lag. For monetary policy changes, the implementation lag is quite short.

The problem of lags suggests that monetary policy should respond not to statistical reports of economic conditions in the recent past but to conditions expected to exist in the future.

Choosing Targets

In attempting to manage the economy, the CB must have some target, or set of targets, that it wants to achieve. Possible targets include interest rates, money growth rates, and the price level or expected changes in the price level.