Types of Monetary Policy

1) Expansionary / Easy Monetary Policy

2) Contractionary / Tight Monetary Policy

Effect of an Easy Monetary Policy

 If real output in the economy is below the full-

employment output, the economy must be experiencing a
recession (a negative GDP gap) and unemployment;
therefore, the CB should institute an easy money policy.

 To increase the money supply, the CB can buy

government securities, lower the legal reserve ratio, and
lower the discount rate.

 Increasing the money supply will reduce interest rates and

will boost investment. This will cause the aggregate
demand curve to shift rightward, eliminating the negative
GDP gap.

Effect of a Tight Monetary Policy

 If real output in the economy is above the full-

employment output, the economy has a positive GDP
gap and demand-pull inflation; the CB should institute a
tight money policy.

 The CB will undertake some combination of the following

 actions:

(1) Sell government securities

(2) increase the Required reserve ratio
(3) increase the discount rate.

 Decreasing the money supply will raise interest rates and

cause investment to decline. The decrease in investment
will shift the aggregate demand curve leftward, eliminating
the excessive spending and halt demand-pull inflation,
closing the positive GDP gap.