Contractionary and expansionary policies involve modifying the level of the money supply in a nation. An expansionary policy increases the supply of money in the economy while a contractionary policy decreases the supply of a country’s currency.
When central banks want to increase the money supply, they do the following:
- Buy securities in the open market;
- Reduce the discounting rate; or
- Lower the reserve requirements.
Each one of these actions affects the interest rate. When the central bank purchases securities on the open market, it leads to an increase in security prices. A discount rate is an interest rate, so when it is lowered, it consequently leads to the reduction of interest rates. When the central bank lowers reserve requirements, it will result in banks increasing the sum of money they can invest. The value on investments such as bonds then raises forcing interest rates to decrease.
The increase in bond prices will affect the exchange market. For example, the rise in American bonds will result in investors selling these bonds in exchange for other bonds, say Australian bonds. As a result, the supply of American dollars will increase in the foreign exchange and decrease the supply of Australian currency.
The effects of contractionary policies are the opposite of expansionary policies. They cause a reduction in bond prices and an increase in interest rates. When the central bank wishes to lower the money supply, it can do the following:
- Sell securities on the open market;
- Increase the discount rate; or
- Increase the reserve requirements of commercial banks.
High-interest rates cause the levels of capital investment to decrease and interest rates end up making domestic bonds more enticing. This causes an increase in the demand for domestic bonds while the demand for foreign bonds declines.
When central banks want to increase the money supply, they perform the following actions, except:
A. Buying securities in the open market.
B. Lowering the reserve requirements.
C. Increasing the discount rate.
The correct answer is C.
Buying securities in the open market and lowering the reserve requirements are ways the central bank can increase the money supply. Increasing the discount rate would have the effect of lowering the money supply.
Reading 18 LOS 18m:
Determine whether a monetary policy is expansionary and contractionary