Question

How do expansionary, tight, contractionary, and loose monetary policy affect aggregate demand?

Short answer

Expansionary (or loose) monetary policies increase aggregate demand by lowering interest rates, which encourages investment and consumption due to cheaper borrowing. Tight and contractionary monetary policies decrease aggregate demand by raising interest rates, discouraging investment and consumption as borrowing becomes more expensive.

Step-by-step solution

1. Expansionary Monetary Policy

An expansionary monetary policy involves the central bank increasing the money supply, by either lowering interest rates or buying financial assets in the open market. This type of policy leads to lower interest rates, which typically causes an increase in investment and consumption as borrowing becomes cheaper. As a result, aggregate demand increases.

2. Tight Monetary Policy

A tight monetary policy involves the central bank decreasing the money supply, primarily by raising interest rates. This type of policy makes borrowing more expensive, which generally leads to a decrease in investment and consumption as firms and households cut back on spending. Consequently, aggregate demand decreases.

3. Contractionary Monetary Policy

A contractionary monetary policy is similar to a tight monetary policy, as it involves the central bank reducing the money supply to increase interest rates. The higher interest rates discourage borrowing, which in turn leads to a decrease in investment and consumption. This reduction in spending causes aggregate demand to decline.

4. Loose Monetary Policy

A loose monetary policy is synonymous with an expansionary monetary policy, in which the central bank increases the money supply, typically by lowering interest rates or purchasing assets in the open market. This decreases the cost of borrowing and encourages investment and consumption, resulting in an increase in aggregate demand. In summary, expansionary (or loose) monetary policies stimulate aggregate demand by lowering interest rates, while tight and contractionary monetary policies dampen aggregate demand by raising interest rates.