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The money supply and how it fights inflation

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Under what circumstances might the Fed consider contracting the money supply (contractionary monetary policy)?

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Solution Summary

The solution gives a detailed defintion of "money supply" and explains the circumstances when this kind of policy (specifically contractionary monetary policy) is appropriate. This answer explains the effects of using monetary policy to influence the economy and when using this policy is effective. The answer also gives a detailed explanation of how changes in the money supply effect the aggregate demand and aggregate supply model.

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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 ...

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