Question

If the economy experiences an inflationary gap, a contractionary monetary policy will __________ investment and _______ interest rates.

Answer 1

Answer:

The correct answer is: Decrease; Increase.

Explanation:

The inflationary gap or inflation is the situation where there is a sustained increase in the general price level. It erodes the purchasing power of the consumers and the real value of money.  

In such a situation a contractionary policy is required to correct the inflationary gap. Such a policy can be either monetary or fiscal.

Contractionary monetary policy is adopted by the Fed to reduce the money supply by using tools such as discount rate, open market operations, reserve ratio, etc.  

These tools are used to reduce the lending capacity of the banks. As the reserves with bank declines. Credit becomes expensive and interest rate increases.  

This raises the cost of borrowing to invest. So the investment will decline as well.