This article discusses the United States Federal Reserves (Fed) interest rate increasing

from 0.5 to 0.75 percent in December 2016. The article accredits this to confidence in the
economic outlook and that inflation will track closer to the two percent target. This is a
contractionary monetary policy, an action taken by the central bank to address a
macroeconomic objective, in this case, reducing inflation.

In this case the policy addresses demand-pull inflation, which occurs when aggregate
demand (AD), the total demand for goods and services, exceeds what the economy can
produce while resources are fixed, shown in the short-run aggregate supply curve (SRAS). This
can be due to factors such as high levels of employment, government expenditure, and
consumer confidence. Price levels (P) rise to return the economy to market equilibrium, resulting
in inflation. This leads to the real GDP exceeding the potential GDP represented by the long-run
aggregate supply (LRAS) creating an inflationary gap. In order to reduce inflation, the Fed policy
works to reduce AD using higher interest rates, as shown below:

Figure 1 - Impact of contractionary monetary policy

 In order to close the inflationary gap and prevent demand-pull inflation, the real GDP
must decrease from Y1 to
YP. The Fed policy uses higher interest rates to reduce the number of
investments, a component of AD. This decrease causes the AD curve to shift leftward from AD1
to AD2. As the article states, the higher rate will affect what the savers and borrower get on
their variable rate. The increased interest rate means an increased cost of borrowing, resulting
in higher costs of investment. This could result in households buying less durable goods, such
as cars, if borrowing money becomes costs more. This is also likely to cause firms to reduce
capital investment as it costs more to take loans and there is less demand for goods.
Furthermore, interest rates on saving accounts could increase as banks pass higher interest
rates to customers, further incentivising households to decrease consumption and save.
Consequently with less AD, the price level decreases from P1 to P2. This shift also causes real
GDP to decrease from Y1 to
YP as economic growth slows.

The use of a contractionary monetary policy is advantageous as monetary policies are

easily implemented and flexible once in place. Should the hiked interest rate not yield the
desired macroeconomic effect, the Fed can raise or lower the interest rate accordingly.
Furthermore, given that monetary policy is governed by the Central Bank, which operates
independently, policies can operate regardless of political stability or popular opinion. However,
there are many uncertainties regarding the macroeconomic effects of a shift in monetary policy
due to the time lag, taking time to reflect observably to real GDP. This could be due to factors
such as fixed interest rates, prior investment projects, and imperfect knowledge between
consumers and the Fed. Furthermore, federal interest rates affects the entire economy and
cannot be used to address a specific problem or target a specific industry or geographic region.
Higher interest rates could be detrimental to sectors already experiencing low levels of
economic activity.

An alternative demand-side policy is fiscal policy, in which the government manipulates

taxes and government spending to achieve a macroeconomic objective. In a contractionary
fiscal policy, the government attempts to reduce AD by increasing taxes and decreasing
government spending. Fiscal policies are advantageous in that they can target specific areas of
the economy to increase taxation or decrease government spending. This is beneficial as it can
also work towards decreasing negative externalities by taxing production and consumption of
demerit goods. The time lag is also shorter than that of monetary policies' as taxes produce
immediate effects while government budgets are adjusted yearly. However, in using a
contractionary policy, governments may face opposition as raising taxes and decreasing
government spending are unpopular. A fiscal policy is difficult to put in place but can be more
effective once implemented.

Given the uncertain nature of inflation, the choice of using monetary policy is
advantageous over fiscal policy as it allows the Fed to adjust interest rates to target a specific
level of AD without political consequences. However, the Fed and the United States government
must be prepared to face unanticipated outcomes. A contractionary monetary policy could
cause a higher unemployment rate, slow economic growth, and decrease AD to the point of a
recession. Additionally, this monetary policy is only effective in the short run, more hikes in
interest rate are to be expected should the economy continue to improve.

Word count: 747

 Reference
Federal Reserve hikes benchmark interest rate to 0.75%. (2016, December 14). Retrieved
January 13, 2017, from
http://www.cbc.ca/news/business/federal-reserve-interest-rate-1.3896402