In a closed economy, what would be the short- and medium-term effects of a monetary contraction, according to the IS-LM-PC model?

In a closed economy, a monetary contraction can have significant short-term and medium-term effects according to the IS-LM-PC model (Investment-Savings, Liquidity preference-Money supply, and Phillips Curve). Here’s a breakdown of the effects:

Short-Term Effects

1. IS Curve Shift: The contraction of the money supply leads to higher interest rates, which decreases investment (I). This results in a leftward shift of the IS curve.

2. LM Curve Shift: With a decrease in the money supply, the LM curve shifts left due to a higher interest rate for any given level of output (Y). This leads to a decrease in both output and income in the short run.

3. Impact on Employment: As aggregate demand falls, firms may reduce production, which can lead to layoffs and higher unemployment rates in the short term.

4. Inflationary Pressures: In the short term, lower aggregate demand also typically results in lower inflation rates as demand for goods and services decreases.

Medium-Term Effects

1. Adjustment of Expectations: As the economy adjusts, expectations about inflation may change. If people expect lower inflation, wages may not rise as quickly, leading to changes in the short-run Phillips Curve.

2. Long-run Output Levels: The economy may eventually return to its potential output (full employment) level, but this process can take time and can be impacted by changes in the labor market and product prices.

3. Persistence of Unemployment: The initial rise in unemployment from the drop in aggregate demand can lead to structural issues if it persists, as skills may become obsolete, leading to a longer-term increase in the natural rate of unemployment.

Summary

• Short-Term: Decrease in output and increase in unemployment, lower inflation.
• Medium-Term: Adjustment in expectations with potential normalization of output, but persistent unemployment issues may arise.

These dynamics highlight the trade-offs policymakers face when implementing monetary policy in a closed economy.