3.5.5—Expansionary and contractionary monetary policy

Expansionary policy lowers rates or eases money to support demand; contractionary policy raises rates or tightens conditions to reduce inflationary pressure.

The effect depends on confidence, debt, exchange rates and spare capacity.

Match policy direction to the macro problem and identify the trade-off.

During a demand slump, lower rates may support investment; near capacity they may add inflation.

Policy direction alone does not guarantee the intended outcome.

For a deflationary/recessionary gap, expansionary policy lowers rates or eases money conditions, encouraging consumption and investment (and often net exports through depreciation), shifting AD right toward potential output. For an inflationary gap, contractionary policy raises rates or tightens conditions, shifting AD left. Draw the initial and new AD with SRAS and the relevant full-employment benchmark; the price-level and real-output effects depend on spare capacity and the AS model.