Contractionary Monetary Policy: Impact on Trade Deficit, Unemployment, and Real Interest Rates

The Effects of Contractionary Monetary Policy

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Question

If the Fed starts following a contractionary monetary policy:

I. the U.S. trade deficit with other countries rises.

II. the unemployment rate increases.

III. real interest rates increase.

Answers

Explanations

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A. B. C. D.

B

When the Fed institutes a contractionary monetary policy, the real interest rates rise because money supply falls. This makes the opportunity cost of current consumption higher, reducing consumer demand and spending. This lower demand leads to lower production and higher unemployment. Further, the U.S. dollar tends to strengthen because foreign investments in U.S. increase due to higher real interest rates. The exports fall due to this. The effect on imports is more ambiguous since reduced consumer spending decreases imports but a stronger dollar increases them. The net effect is usually seen to be an increase in trade deficit due to a larger fall in exports.

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