Question

In a basic AD-AS model, if the economy is at the equilibrium on the far left of the potential real output level, then a contractionary monetary policy will

Answer 1

Answer: The contractionary monetary policy will be used to reduce the supply of money in circulation.

Explanation:

The Aggregate demand AD is the total demand for a final goods and services in the economy at a given period of time and at a general price level. It is a demand for the GDP of a country. While AS is the supply for final goods and services in the economy at a given period of time.,when AD for the goods and services is more than the AS of goods and services, it leads to the general rise in prices which is generally refered to as the demand pull inflation. In the situation of demand pull inflation there is no increase in real output and employment in the economy. The rise in prices of goods and services will arise due to increase in demand, the increase in prices therefore occur in terms of money because too much money is chasing fewer goods which increase the prices and causes inflation.

In a period of inflation like this the central bank will use the contractionary monetary policy to reduce the supply of money in circulation in order to mop up the excess liquidity in the economy through the use of monetary policy instruments such as open market operation. The central bank can also use the bank rate, by increasing the bank rate this will make the interest rate to be high,it will discourage the commercial bank from borrowing and lending to the people. In addition to that, the central bank may also require the commercial bank to keep with it special deposit over and above their statutory requirements, The central bank can also use cash reserve ratio otherwise known as liquidity ratio which requires commercial bank to keep a certain percentage of their total cash with the central bank. All these are done in an attempt by the central bank to control inflation.

Answer 2

Answer: it will reduce the potential output

Explanation:

contractionary monetary policy will increase interest rate and reduce inflation which caused out of control growth.