Working of Contractionary Monetary Policy: A Diagrammatic Presentation

Monetary policy is central bank’s policy to govern the money supply and interest rates in the economy to influence output, employment, and prices. The main instruments of monetary policy include open market operations, repo rate, reserve requirements for banks etc. Monetary policy has many objectives like controlling inflation, promoting growth and employment and ensuring stability in exchange rate and Balance of Payments. Monetary policy is considered to be a very effective tool especially in controlling the inflation. The central bank usually adopts a contractionary monetary policy to contain the prices. A contractionary monetary policy is the one in which the central bank increases the interest rate, CRR and resorts to open market sales of government securities with the goal of reducing the aggregate demand in the economy. This contraction in aggregate demand helps in controlling the prices. The current paper strives to diagrammatically explain the working of a contractionary monetary policy for checking the inflation. The first section explains the concept of monetary policy. The second section elucidates the meaning of contractionary monetary policy. The third section illustrates the derivation of aggregate demand curve. The fourth section enlists some of the most common reasons for inflation whereas the final section explains the working of the contractionary monetary policy using diagrams.