ECONOMICS (CBSE/UGC NET)

Detailed explanation-1: -The inflation level is the main target of a contractionary monetary policy. By reducing the money supply in the economy, policymakers are looking to reduce inflation and stabilize the prices in the economy.

Detailed explanation-2: -So the first thing that happens with a decrease in the money supply is that interest rates rise. As interest rates rise, businesses are less willing to invest to borrow for investment spending. And consumers, too, are less willing to borrow to buy cars and homes and so on. Thus spending decreases.

Detailed explanation-3: -The Federal Reserve uses contractionary monetary policy to curb inflation that accompanies an overheating economy.

Detailed explanation-4: -Note that the goal of contractionary monetary policy is to decrease the rate of demand for goods and services, not to stop it. So, higher interest rates through contractionary policy can be used to dampen inflation and move the economy back to the price stability component of the dual mandate.

Detailed explanation-5: -The Federal Reserve seeks to control inflation by influencing interest rates. When inflation is too high, the Federal Reserve typically raises interest rates to slow the economy and bring inflation down.