Answer to Question #209652 in Macroeconomics for Gouri

Question

Contractionary policies are designed to slow economy and reduce inflation

by decreasing aggregate demand and aggregate output. Explain why contractionary fiscal policy and

contractionary monetary policy have opposite effects on the interest rate despite having the same

goal of decreasing aggregate demand and aggregate output. Illustrate your answer with graphs of

the money market.

Answer 1

Solution:

Contractionary fiscal policy is normally adopted by the government in order to tackle expected inflation through reduced spending and hence reducing its borrowing. As such, the available funds in the credit market increase resulting in a fall in the interest rates.

On the other hand, contractionary monetary policy is a policy that is usually adopted by the central bank or federal bank with the aim of tackling inflation by reducing the money supply in the economy to avoid rampant speculation and unsustainable capital investment by increasing interest rates.

 

The two situations have been demonstrated by the below two graphs: