Answer to Question #214532 in Macroeconomics for Maht

Question

with the aid of the Phillip's curve explain what happens to unemployment in the shorts run and in the long -run if central bank unexpectedly pursues contractionary monetary policy

Answer 1

Contractionary Monetary Policy

The central bank, at some point, needs to control the interest rates and supply of money in an economy. They achieve this by using a tool called monetary policy (Deshpande, 2020). Monetary policy is categorized into; contractionary monetary policy and expansionary monetary policy. When it comes to contractionary monetary policy, the bank increases the interest and allows free-market sales of government securities to reduce average demand in the economy. Contractionary money policy is applied to control prices/inflation. By increasing the interest rate, the bank reduces the money supply in the economy and reduces inflation. Arguably, contractionary monetary policy can slow down economic growth, leading to increased unemployment (Deshpande, 2020).

The Philips curve provides an inverse relationship between inflation and unemployment (Abu, 2019). The Philips curve demonstrates this with a downward curve where on the Y-axis is inflation and on the X-axis is unemployment. This means, increase in inflation results in a decrease in unemployment, and likewise, a decrease in inflation leads to an increase in unemployment. However, according to Vermeulen (2017), there is no indication of a relationship between employment inflation in the short run. Still, in the long- run, there is an adequate indication of a positive relationship between employment and inflation. In that case, the effects of inflation on employment in the short run are minimal or not there, but the effect of inflation on employment is there in the long run.

Therefore, going by Philip's curve, if the central bank implements the contractionary monetary policy, there won't be much impact on employment in the short run, but unemployment will increase in the long run. With time, implementation of the contractionary monetary policy will reduce interest and, therefore, a reduction in money supply in the economy (Vermeulen, 2017). This implies that there will be a slow-down in production, trade, agriculture, and all other economic activities with time. Once the economic activities are reduced, the demand for labor also reduces (Deshpande, 2020). Reduction in money supply due to contractionary monetary policy will, with time, lower the population's purchasing power. Once the purchasing power is reduced, the demand for goods and services reduces hence affecting trade. This again will result in a reduction in the labor demand. 

While the main aim of contractionary monetary policy is to control inflation, money supply, and prices, in the long run, it brings about a negative impact on the economy of the country, and this leads to increased unemployment. The central bank should therefore ensure close monitory of the economic statistics while implementing the monetary policy. If the bank starts implementing contractionary monetary policy, the policy immediately starts slowing down economic productivity. The bank should shift from a contractionary monetary policy to an expansionary monetary policy (Deshpande, 2020). This move will help the economy to return to its optimal performance. The monetary policies should be avoided when there is an optimum money supply, prices of the product, and economic performance.

 

 

 

 

 

 

References

Deshpande, S. S. (2020). Working of Contractionary Monetary Policy: A Diagrammatic Presentation.

Abu, N. (2019). Inflation and Unemployment Trade-off: A Re-examination of the Phillips Curve and its Stability in Nigeria. Contemporary economics, 13(1), 21-35.

Vermeulen, J. C. (2017). Inflation and unemployment in South Africa: Is the Phillips curve still dead?. Southern African Business Review, 21(1), 20-54.