Question

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

Short answer

In summary, expansionary monetary policy increases the quantity of money in the economy through actions such as lowering interest rates, purchasing government bonds, and increasing bank reserves. Conversely, contractionary monetary policy decreases the quantity of money in the economy by raising interest rates, selling government bonds, and decreasing bank reserves. The central bank uses these policies to stimulate economic growth or prevent inflation and maintain economic stability.

Step-by-step solution

Understand Expansionary and Contractionary Monetary Policies

Expansionary monetary policy refers to actions taken by a central bank to increase the quantity of money and credit in the economy. These actions are typically aimed at stimulating economic growth, lowering unemployment, or combating deflation. Some common tools used in expansionary monetary policy include lowering interest rates, purchasing government bonds, and increasing bank reserves. On the other hand, contractionary monetary policy refers to actions taken by a central bank to decrease the quantity of money and credit in the economy. These actions are aimed at preventing inflation or in response to an overheating economy. Common tools used in contractionary monetary policy include raising interest rates, selling government bonds, and decreasing bank reserves.

Observe the Effects of Expansionary Monetary Policy on the Quantity of Money

When a central bank implements expansionary monetary policy, they take specific actions aiming to increase the quantity of money in an economy. The steps to analyze this can be: 1. Lowering the interest rates: Central banks control the base interest rates, which in turn influences the overall interest rates in the economy. When interest rates are lower, people are more inclined to borrow money for consumption and businesses to invest in projects, leading to financial institutions to provide more loans. This results in a higher money supply. 2. Purchasing government bonds: The central bank can buy bonds in the open market, effectively increasing the price of bonds, lowering the yield, and providing the sellers with newly created money in exchange for their bonds. The sellers of these bonds will deposit the money into their banks, adding to the overall quantity of money in the economy. 3. Increasing bank reserves: When the central bank requires banks to hold fewer reserves, they can loan out more of their deposits, therefore, increasing the quantity of money in the economy.

Observe the Effects of Contractionary Monetary Policy on the Quantity of Money

When a central bank implements contractionary monetary policy, they take specific actions aiming to decrease the quantity of money in an economy. The steps to analyze this can be: 1. Raising interest rates: By raising interest rates, the cost of borrowing money increases, and so people and businesses are less likely to seek loans. This results in a decreased money supply. 2. Selling government bonds: The central bank can sell bonds in the open market, effectively decreasing the price of bonds and raising the yield. Those who buy the bonds pay the central bank with money from their bank deposits, effectively taking money out of the economy. 3. Decreasing bank reserves: If the central bank requires banks to hold more reserves, banks have less available funds to loan out, thus decreasing the quantity of money in the economy. By understanding the different tools used in expansionary and contractionary monetary policies, we can analyze how each policy affects the quantity of money in the economy. Expansionary policies increase the money supply, while contractionary policies decrease it.