Contractionary Monetary Policy:

A form of monetary policy in which a decrease in the money supply and a increase in interest
rates are used to correct the inflationary problems of a business-cycle expansion. In theory,
contractionary monetary policy can include an increase in the discount rate, and an increase in
reserve requirements. In theory, open market operations are the primary tool of contractionary
monetary policy. Contractionary monetary policy is often supported by contractionary fiscal
policy.
Contractionary monetary policy is a decrease in the quantity of money in circulation, with
corresponding increases in interest rates, for the expressed purpose of putting the brakes on an
overheated business-cycle expansion and to address the problem of inflation.
Contractionary Monetary Policy with Graph:

Asthemoneysupplyiscontracted,interest
ratesrise,investmentwillfall,
consumptionwillfallandnetexportswill
fall.
Peoplemakeaportfoliochoice.Peoplewill
choosetoholdmorebondsthantheydid
beforebecausethereturnonabondhas
risen(ihasgoneup).

i =people invest in dollar denominated asset. So, buy dollars = value of dollar rises

The Effects of Monetary Policy on Real GDP and the Price Level:
In panel the economy begins at point A, with real GDP at $14.2 trillion and
the price level at 102.

A contractionary monetary policy

causes aggregate demand to shift to
the left, from AD1 to AD , decreasing
real GDP from $14.2 trillion to $14.0
trillion and the price level from 102 to
100 (point B).
2

With real GDP back at its potential

level, the Fed can meet its goal of price
stability.