Analyzing Contractionary Monetary Policy: Effects on Economy

This essay examines the effects of contractionary monetary policy, a common tool used to curb inflation, on unemployment and income inequality. It explains how reducing the money supply leads to higher interest rates, decreased capital investment, and ultimately, increased unemployment, ...Read More

Running Head: CONTEMPORARY ISSUES IN ECONOMICS
Contemporary Issues in Economics
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1CONTEMPORARY ISSUES IN ECONOMICS
Table of Contents
Contractionary monetary policy and unemployment......................................................................2
Contractionary monetary policy and income inequality..................................................................3
Reference list...................................................................................................................................5

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Contractionary monetary policy and unemployment
Contractionary monetary policy is a standard practice for curbing inflation. The direct
impact of monetary contraction is on the interest rate. The reduced money supply during
contractionary monetary policy raise the interest rate. The investors have to bear a larger interest
cost. With low capital investment production slowed down. The increased interest rate and
slowed down production affects the unemployment rate in the economy. When firms’ growth
contract along then they laid off workers and stops hiring new workers. This contributes to an
increase in unemployment (Agénor and Montiel 2015). The increased unemployment thus is a
by-product of contractionary policy and lead to further contraction of economy. High
unemployment reduces consumer confidence resulting in an increase in a decline in consumption
demand. This claim is supported the standard macroeconomic theory of Phillips curve that
depicts an inverse relation between inflation and unemployment. Following this theory, lower
inflation is accompanied with increased unemployment. The effect of monetary policy on
unemployment can be explained with the help of IS-LM model.

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Figure 1: Effect of contractionary monetary policy
(Source: as created by Author)
Contractionary monetary policy taken in the form of a reduction in available money
supply. LM curve reflects the equilibrium in the money market (Bernanke, Antonovics and
Frank 2015). When money supply reduces then LM curve shift to the left from LM to LM1.
Given commodity market equilibrium by IS, a new equilibrium is obtained to the left of old
equilibrium. Consequently, GDP declines from Y1 to Y2 and interest rate increases from r1 to r2.
As the economy contracts production declines leading to an increase in unemployment.
Contractionary monetary policy and income inequality
Inequality though not comes under direct objectives of central bank, there are channels
through which monetary policy affect income distribution and hence, income inequality. The
first channel is income composition channel. There are some households in the economy that
depends on business and income from other financial source. In times of contractionary
monetary policy business contracts and profit declines. The most of the wealthier class depends
of such profits or financial income their income declines and inequality may narrow down. The
next channel is the channel for financial segmentation. Individuals involve in transaction in the
financial market are largely affected by the changes occur in the supply of money (Heijdra
2017). When central bank adapts contractionary monetary policy then these groups face a
reduction in income. The extent of monetary policy on the income distribution depends on how
deeply individual involve in the money market transaction. As these groups tends to be mostly
wealthier class of the society inequality may decline following a contractionary monetary policy.
The third channel to affect income distribution is the portfolio channel. If in the economy,

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households belong to low income group have a tendency to hold more cash and a relatively
lower financial asset as compared to high-income household then the inflation action taken by
the monetary authority represents income transfer from the low income group to the high
income. This again affects income inequality. Because of contraction monetary policy
unemployment in the income increases. The increased unemployment among low income
household increases income inequality (Mankiw 2014). Henceforth, contractionary monetary
policy has an ambiguous effect on income inequality. The effect depends on relative strength of
different channels.

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Reference list
Agénor, P.R. and Montiel, P.J., 2015. Development Macroeconomics Fourth edition. Economics
Books.
Bernanke, B., Antonovics, K. and Frank, R., 2015. Principles of macroeconomics. McGraw-Hill
Higher Education.
Heijdra, B.J., 2017. Foundations of modern macroeconomics. Oxford university press.
Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.