Question

Why does contractionary monetary policy cause interest rates to rise?

Short answer

Contractionary monetary policy causes interest rates to rise because it decreases the money supply in the market, leading to a scarcity of funds for borrowing. As borrowing becomes more expensive, the demand for money decreases, and the supply of funds increases. This results in a new market equilibrium with higher interest rates, helping the central bank combat inflation and cool down an overheated economy.

Step-by-step solution

Understand Monetary Policy

Monetary policy is the tool used by central banks to control the money supply in the economy. There are two types of monetary policy: expansionary and contractionary. Expansionary policy aims to increase the money supply, while contractionary policy aims to decrease it. The central bank usually implements monetary policy by adjusting the interest rates or buying and selling government bonds in the open market.

Contractionary Monetary Policy

Contractionary monetary policy is employed when the central bank wants to reduce the money supply to fight inflation or cool down an overheated economy. The central bank uses this policy to decrease the amount of available funds in the financial markets, which typically leads to an increase in borrowing costs (interest rates) for individuals and businesses.

Demand and Supply of Money

The level of interest rates in an economy can be determined by the supply and demand for money. The money supply is mainly affected by the central bank's monetary policy decisions, while demand for money is influenced by various factors like the perceptions of consumers and businesses towards the future state of the economy and the need for borrowing.

Impact of Decreased Money Supply

When the central bank implements contractionary monetary policy, the money supply decreases. This reduces the availability of funds in the market, making borrowing more difficult and expensive. Consequently, the cost of borrowing (interest rate) increases due to scarcity of funds.

Market Equilibrium

As borrowing becomes more expensive with higher interest rates, businesses and individuals demand less credit, while lenders/investors supply more funds, seeking to take advantage of the increased profit margins. As a result, the money market reaches a new equilibrium, characterized by a higher interest rate level than before.

Conclusion

Contractionary monetary policy leads to an increase in interest rates because it decreases the money supply in the market. This causes a scarcity of funds, making borrowing more expensive. As a result, the demand for money decreases, and the supply of funds increases, leading to higher interest rates as a new market equilibrium is established. This helps the central bank achieve its goals of curbing inflation and cooling down an overheated economy.