Expansionary & Contractionary Monetary Policy (Cambridge International A-Level Economics)

Expansionary monetary policy

• Expansionary monetary policy involves reducing interest rates, increasing the money supply (including through quantitative easing), or loosening credit regulations - with the aim of increasing aggregate demand in the economy

• To understand the effects of monetary policy on an economy, it is useful to know how aggregate demand (AD) is calculated

  • AD= household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)
  • AD = C + I + G + (X - M)

• From this, it is logical that changes to monetary policy can influence any of these components - and often several of them at once

AD/AS diagram illustrating expansionary monetary policy

Diagram analysis

• The economy is initially in macroeconomic equilibrium AP₁Y₁
• The Central Bank wants to boost economic growth and lower interest rates
• Lower interest rates cause investment and consumption to increase, which are components of AD
• Aggregate demand increases from AD₁→ AD₂
• The economy reaches a new equilibrium at AP₂Y₂ - a higher average price level and a greater level of national output
• As real output rises from Y1 to Y2, firms require more workers - employment rises and unemployment falls

An example of how expansionary monetary policy works

Worked Example Which combination would represent the most expansionary set of monetary policies?

	Credit availability	Interest rates	Money supply
A	increased	up	reduced
B	increased	down	increased
C	reduced	up	increased
D	reduced	down	reduced

Final answer: Answer: B

Worked solution:

Assess each tool against its expansionary direction:

• Credit availability - increasing availability makes borrowing easier, stimulating consumption and investment - expansionary. Options C and D reduce credit - contractionary. Eliminates C and D
• Interest rates - cutting rates reduces the cost of borrowing and the return on saving, raising consumption and investment - expansionary. Option A raises rates - contractionary. Eliminates A
• Money supply - increasing money supply puts more money into circulation, reducing interest rates and stimulating spending - expansionary. Option B increases money supply - confirms B

All three tools in option B point in the same expansionary direction. The trap is option A - two tools are expansionary but raising interest rates is contractionary, making it a mixed rather than the most expansionary combination.

Contractionary monetary policy

• Contractionary monetary policy involves raising interest rates, stopping/reducing quantitative easing or reducing the amount of credit, with the aim of decreasing aggregate demand in the economy

Keynesian diagram illustrating contractionary monetary policy

Diagram analysis

• The economy is initially in macroeconomic equilibrium AP₁Y_FE
• The central bank is wanting to lower inflation towards its target rate
• Higher interest rates cause investment and consumption to decrease
• Aggregate demand decreases from AD₁→ AD₂
• As real output falls from YFE to Y1, firms require fewer workers - employment falls and unemployment rises
• The economy reaches a new equilibrium at AP₂Y₁ - a lower average price level and a smaller level of national output

An example of how contractionary monetary policy works

Case Study Contractionary monetary policy - United States 2022-2023

The context

US inflation rose to 9.1% in June 2022 - its highest level since 1981 - driven by post-pandemic demand surges, supply chain disruptions and rising energy prices. The Federal Reserve responded with its fastest tightening cycle in decades.

Actions taken

• The Federal Reserve raised the federal funds rate from near zero in March 2022 to 5.25-5.50% by July 2023 - eleven consecutive increases over sixteen months
• Higher rates increased mortgage costs, credit card rates and business borrowing costs, reducing consumption and investment
• The Fed also began reducing the quantitative easing of the pandemic period by selling bonds and withdrawing money from circulation

Outcomes

• Inflation fell from 9.1% in June 2022 to approximately 3.2% by October 2023 - a significant reduction achieved without triggering a recession
• GDP growth slowed but remained positive throughout, and unemployment stayed below 4% - leading economists to describe it as a rare "soft landing"
• The case illustrates that contractionary monetary policy can reduce inflation without necessarily causing large falls in output and employment - though the Fed itself acknowledged the outcome was better than most models predicted
• It also shows all three monetary policy tools working together - higher interest rates, tighter credit conditions and reduced money supply reinforcing each other to shift AD left

Exam Hint Always state the full transmission mechanism when analysing monetary policy - do not simply say "cutting interest rates increases AD." The chain must include: rates fall - cost of borrowing falls and return on saving falls - consumption and investment rise - AD shifts right - real output, price level and employment rise.

The key distinction between the three tools is that interest rates affect the cost of borrowing, money supply affects the volume of money in circulation, and credit regulations affect the availability of borrowing. All three shift AD but through different channels.

In an exam question asking which tool is most appropriate, consider which channel is most relevant to the economic problem described.