Question

Take a look at Figure 16-6. Suppose that a multiple reduction in GDP is the final outcome that the Fed desires in the last box in the figure. Explain the required directions of efforts - that increases or decreases - that most occur in the preceding boxes in the figure in order to yield in this desired decrease in real GDP

Short answer

Contractionary monetary policy reduces excess reserves & credit creation, liquidity in the economy. It increases interest rates & decreases investment, aggregate demand & real GDP

Step-by-step solution

Monetary Policy & Money Supply Concept 

Monetary Policy is the central bank's credit policy used to control money supply in the economy

• Increase in Bank rate, Increase in Legal Reserve Ratio, Increase in Marginal requirement are credit & money, GDP contraction tools

They decrease the monetary (excess) reserves of commercial banks, which further decrease their credit creation capacity and money supply in the economy.

Interest Rates, Investment & Real GDP Concept 

• Decrease in money supply (due to credit contraction monetary policy) lead increase in interest rates respectively, as interest is the price of money.
• Increase interest rates implies corresponding decrease in investment.
• Decrease in investment increases or decreases Aggregate Demand & real GDP (total value of goods & services in economy) further.