In the market for money everything else equal what would hap

In the market for money, everything else equal, what would happen if the central bank contracts the money supply? explain the chain of events.

Solution

When central bank contacts money supply, interest rate rises to combat excess demand as demand for money is unchanged. Higher interest rate leads to decrease in demand for investment as higher interest rate is a higher cost of borrowing.

Lower investment spending further leads to decrease in aggregate demand. Decrease in aggregate demand results in lower output and lower prices, aggregate supply being unchanged. Thus central bank contracting money supply results in lower output produced and lower inflation.