Question

Which kind of monetary policy would you expect in response to high inflation: expansionary or contractionary? Why?

Short answer

In response to high inflation, we would expect a contractionary monetary policy. This is because contractionary policies are designed to slow down inflation by reducing borrowing and spending in the economy, which decreases demand for goods and services, leading to lower prices and a reduction in inflation. Central banks implement contractionary monetary policies to maintain the stability of the economy, preserve purchasing power, and promote sustainable economic growth.

Step-by-step solution

Define Expansionary Monetary Policy

Expansionary monetary policy is a type of monetary policy implemented by central banks to stimulate economic growth, typically through lowering interest rates or increasing the money supply. The goal is to encourage more borrowing and spending by individuals and businesses, leading to increased production and growth in the economy.

Define Contractionary Monetary Policy

Contractionary monetary policy is implemented by central banks to slow down economic growth, often in response to high inflation. These policies generally involve raising interest rates or decreasing the money supply. The purpose is to dampen borrowing and spending by individuals and businesses, which in turn reduces production and slows inflation.

Assess the effect of high inflation

High inflation occurs when the general price levels for goods and services are rising at an abnormally high rate, which can erode purchasing power and destabilize an economy. It can lead to a vicious cycle of increasing prices, reduced spending, and stagnant growth. Controlling inflation is crucial to maintain a stable economy and protect people's income.

Choose the appropriate monetary policy

In response to high inflation, the appropriate monetary policy would generally be contractionary. This is because contractionary policies are specifically designed to slow down inflation by reducing borrowing and spending in the economy. With less money flowing through the economy, the demand for goods and services decreases, which in turn leads to lower prices and a reduction in inflation.

Explain why contractionary monetary policy is the expected response

Contrary to expansionary policies, which could exacerbate inflation by further stimulating borrowing and spending, contractionary policies are aimed at controlling and reducing inflation. By implementing contractionary monetary policies, central banks can maintain the stability of the economy by keeping inflation within targeted levels. This helps to preserve the purchasing power of individuals and businesses, promoting sustainable economic growth.