{"id":1367,"date":"2019-09-12T13:33:00","date_gmt":"2019-09-12T13:33:00","guid":{"rendered":"https:\/\/analystprep.com\/cfa-level-1-exam\/?p=1367"},"modified":"2026-01-09T18:32:43","modified_gmt":"2026-01-09T18:32:43","slug":"expansionary-contractionary-monetary-policies","status":"publish","type":"post","link":"https:\/\/analystprep.com\/cfa-level-1-exam\/economics\/expansionary-contractionary-monetary-policies\/","title":{"rendered":"Expansionary and Contractionary Monetary Policies"},"content":{"rendered":"\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"VideoObject\",\n  \"name\": \"Monetary and Fiscal Policy (2022 Level I CFA\u00ae Exam \u2013 Reading 12)\",\n  \"description\": \"This CFA Level I lecture covers key macroeconomic concepts, comparing monetary and fiscal policy, money creation, inflation impacts, and the Fisher effect. It explains central bank roles, monetary tools, transmission mechanisms, and policy limitations. The session also addresses fiscal tools, national debt concerns, and coordination between government and central banks.\",\n  \"uploadDate\": \"2018-11-12T00:00:00+00:00\",\n  \"thumbnailUrl\": \"https:\/\/i.ytimg.com\/vi\/KKHi1HKTpD4\/hqdefault.jpg\",\n  \"contentUrl\": \"https:\/\/www.youtube.com\/watch?v=KKHi1HKTpD4\",\n  \"embedUrl\": \"https:\/\/www.youtube.com\/embed\/KKHi1HKTpD4\",\n  \"duration\": \"PT29M18S\"\n}\n<\/script>\n<script type=\"application\/ld+json\">\n{\n  \"@context\": \"https:\/\/schema.org\",\n  \"@type\": \"QAPage\",\n  \"mainEntity\": {\n    \"@type\": \"Question\",\n    \"name\": \"Central bank actions to decrease the money supply\",\n    \"text\": \"Which of the following is most likely an example of a central bank action if it wants to decrease the money supply?\\n\\nA. Buying securities in the open market\\n\\nB. Lowering the reserve requirements\\n\\nC. Increasing the discount rate\",\n    \"answerCount\": 1,\n    \"acceptedAnswer\": {\n      \"@type\": \"Answer\",\n      \"text\": \"The correct answer is C.\\n\\nIncreasing the discount rate raises the cost of borrowing from the central bank, which discourages banks from borrowing and lending, thereby reducing the money supply.\\n\\nBuying securities in the open market and lowering reserve requirements both increase the money supply and are therefore incorrect.\"\n    }\n  }\n}\n<\/script>\n\n\n\n\n<iframe loading=\"lazy\" width=\"560\" height=\"315\" src=\"https:\/\/www.youtube.com\/embed\/KKHi1HKTpD4?si=haWKajOolPgeMCCV\" title=\"YouTube video player\" frameborder=\"0\" allow=\"accelerometer; autoplay; clipboard-write; encrypted-media; gyroscope; picture-in-picture; web-share\" referrerpolicy=\"strict-origin-when-cross-origin\" allowfullscreen><\/iframe>\n\n\n\n<p>Contractionary and expansionary policies involve modification of the level of money supply in an economy. An expansionary policy increases the supply of money in an economy. On the other hand, a contractionary policy decreases the supply of a country\u2019s currency.<\/p>\n\n\n\n<!--more-->\n\n\n\n<h2 class=\"wp-block-heading\"><strong>Expansionary Policy<\/strong><\/h2>\n\n\n\n<p>When central banks want to increase the money supply, they do the following:<\/p>\n\n\n\n<ul class=\"wp-block-list\">\n<li>buy securities in the open market;<\/li>\n\n\n\n<li>reduce the discount rate; or<\/li>\n\n\n\n<li>lower the reserve requirements.<\/li>\n<\/ul>\n\n\n\n<p>Each one of these actions affects the interest rate.<\/p>\n\n\n\n<div style=\"margin: 0 0 20px 0;\">\n  <a\n    href=\"https:\/\/analystprep.com\/free-trial\/\"\n    target=\"_blank\"\n    rel=\"noopener noreferrer\"\n    style=\"\n      display: inline-block;\n      border: 2px solid #1e63ff;\n      color: #1e63ff;\n      background: #ffffff;\n      padding: 10px 14px;\n      border-radius: 10px;\n      font-weight: 500;\n      line-height: 1.35;\n      text-decoration: none;\n    \"\n  >\n    Want to practice expansionary and contractionary monetary policy concepts tested on CFA Level I? Try AnalystPrep\u2019s free trial now.\n  <\/a>\n<\/div>\n\n\n\n<h4>Open Market Operations<\/h4>\n<p>When the central bank purchases securities in the open market, it increases security prices. Because of the inverse relationship between bond prices and interest rates, increasing bond prices will decrease interest rates.<\/p>\n<p>The increase in bond prices will also 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 market while the supply of Australian currency will decline.<\/p>\n<h4>Discount Rate<\/h4>\n<p>A discount rate is an interest rate, so when it is lowered, it leads to reduced interest rates. Given such a development, businesses and consumers will be more willing to take loans. This, in turn, will increase consumption and investments.<\/p>\n<h4>Reserve Requirements<\/h4>\n<p>When the central bank lowers reserve requirements, commercial banks increase the sum of money they can lend to consumers and businesses. This also increases consumption and investments.<\/p>\n<h2><strong>Contractionary Policy<\/strong><\/h2>\n<p>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:<\/p>\n<ul>\n<li>sell securities in the open market;<\/li>\n<li>increase the discount rate; or<\/li>\n<li>increase the reserve requirements of commercial banks.<\/li>\n<\/ul>\n<p>High interest rates cause the levels of capital investment to decrease. Further, interest rates make domestic bonds more enticing. This causes an increase in the demand for domestic bonds while the demand for foreign bonds declines. As a result, the supply of domestic currency decreases in the foreign exchange market.<\/p>\n<blockquote>\n<h2><strong>Question<\/strong><\/h2>\n<p>Which of the following is<em> most likely<\/em> an example of a central bank action if it wants to decrease the money supply?<\/p>\n<p>A. Buying securities in the open market<\/p>\n<p>B. Lowering the reserve requirements<\/p>\n<p>C. Increasing the discount rate<\/p>\n<p><strong>Solution<\/strong><\/p>\n<p>The correct answer is C.<\/p>\n<p>Increasing the discount rate would have the effect of lowering the money supply.<\/p>\n<p>Options A and B are incorrect. Buying securities in the open market and lowering the reserve requirements are ways the central bank can increase the money supply.<\/p>\n<\/blockquote>\n<p><em>Reading 16 LOS 16m: <\/em><\/p>\n<p><em>Determine whether a monetary policy is expansionary and contractionary<\/em><\/p>\n\n\n<div style=\"text-align: center; margin: 32px 0;\">\n  <a\n    href=\"https:\/\/analystprep.com\/free-trial\/\"\n    target=\"_blank\"\n    rel=\"noopener noreferrer\"\n    style=\"\n      display: inline-block;\n      background-color: #1e63ff;\n      color: #ffffff;\n      padding: 12px 26px;\n      border-radius: 12px;\n      font-weight: 600;\n      font-size: 16px;\n      text-decoration: none;\n    \"\n  >\n    Start Free Trial \u2192\n  <\/a>\n\n  <div style=\"margin-top: 10px; font-size: 14px; color: #374151;\">\n    Practice CFA Level I economics questions on central bank tools, interest rates, money supply, and economic outcomes with clear solutions.\n  <\/div>\n<\/div>\n\n\n\n\n<p><\/p>\n","protected":false},"excerpt":{"rendered":"<p>Contractionary and expansionary policies involve modification of the level of money supply in an economy. An expansionary policy increases the supply of money in an economy. On the other hand, a contractionary policy decreases the supply of a country\u2019s currency.<\/p>\n","protected":false},"author":3,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[4],"tags":[],"class_list":["post-1367","post","type-post","status-publish","format-standard","hentry","category-economics","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Expansionary &amp; Contractionary Monetary Policy | CFA Level 1<\/title>\n<meta name=\"description\" content=\"Understand how central banks use expansionary and contractionary policies to manage inflation, control interest rates, and stabilize the economy.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" 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