Question

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

Short answer

In summary, expansionary monetary policy aims to increase the quantity of money in the economy by using tools such as open market operations, lowering reserve requirements, and lowering the discount rate. This stimulates economic activity by making it easier for businesses and consumers to borrow money. On the other hand, contractionary monetary policy aims to decrease the quantity of money in the economy by using tools such as selling government securities, raising reserve requirements, and raising the discount rate. This helps to slow down an overheated economy and control inflation by making it more difficult for businesses and consumers to borrow money.

Step-by-step solution

1. Goals of Monetary Policy

Monetary policy refers to the actions taken by a central bank to influence the supply of money and credit in an economy, in order to achieve macroeconomic objectives, such as price stability and economic growth. The central bank can implement expansionary or contractionary monetary policies depending on the current economic situation and the desired macroeconomic outcomes.

2. Tools Used in Monetary Policies

Central banks have a range of tools at their disposal to implement monetary policy. Some of the most common tools include: - Open market operations (OMO): Central banks buy or sell government securities on the open market to influence the money supply and interest rates. - Reserve requirements: Central banks can change the minimum amount of reserves that commercial banks must hold, which in turn affects the money supply. - Discount rate: The central bank can influence the interest rate at which it lends money to commercial banks, which affects the cost of borrowing for banks and ultimately influences interest rates and the money supply in the broader economy.

3. How Expansionary Monetary Policy Affects Quantity of Money

An expansionary monetary policy aims to increase the money supply and lower interest rates to stimulate economic activity. When a central bank implements expansionary monetary policy, it can use the tools mentioned above in the following ways: - Open market operations (OMO): The central bank buys government securities on the open market, thereby injecting money into the financial system and increasing the money supply. - Lowering reserve requirements: By lowering the reserve requirements, commercial banks can hold fewer reserves and lend out more money to businesses and consumers, thereby increasing the money supply. - Lowering the discount rate: A lower discount rate reduces the cost of borrowing for commercial banks. As a result, banks increase their lending activities, and the money supply in the economy expands. In general, during an expansionary monetary policy, the quantity of money in the economy increases.

4. How Contractionary Monetary Policy Affects Quantity of Money

A contractionary monetary policy aims to decrease the money supply and raise interest rates to slow down an overheated economy and control inflation. When a central bank implements contractionary monetary policy, it can use the tools mentioned above in the following ways: - Open market operations (OMO): The central bank sells government securities on the open market, thereby taking money out of the financial system and decreasing the money supply. - Raising reserve requirements: By raising the reserve requirements, commercial banks have to hold more reserves and have less money to lend out to businesses and consumers, thereby decreasing the money supply. - Raising the discount rate: A higher discount rate increases the cost of borrowing for commercial banks. As a result, banks may reduce their lending activities, and the money supply in the economy contracts. In general, during a contractionary monetary policy, the quantity of money in the economy decreases.