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Under what circumstances might the Fed want to shrink (contract) the money supply?
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The first step in answering this problem is to have a clear understanding of the term money supply. In economics, "money supply" is the total amount of money existing in an economy at a specific moment in time. While there are many ways to define "money", the traditional definition generally considers currency in circulation and demand deposits (the term demand deposits refers to money that is accessible in deposit accounts held at a bank or other financial institution so that the funds may be retrieved on demand). When economists refer to shrinking or contracting the money supply, they are referring to decreasing the amount of hard currency available in an economy. This is achieved through raising the federal discount rate, reducing the monetary base through open market operations, and/or increasing reserve requirements.
The Fed might want to shrink the monetary supply in order to achieve policy goals. In order to understand the policy goal behind a reduction in money supply it is important to first understand the effects of altering the money supply. The direct effect of a decrease in the money supply is that people purchase less goods and services because they have less ...
This solution reviews in detail the definition of the term money supply, why the Fed might want to shrink the money supply in order to achieve certain policy goals, the purpose of engaging in contractionary policy to close the inflationary gap in an economy, how net exports affects this analysis, and why the Fed fears inflation.