Question

Would you advocate expansion or contraction of money supply during excess demand?

Answer 1

Excess demand is the excess of aggregate demand over and above its level required to maintain full employment equilibrium in the economy. Excess demand in an economy causes inflation, that is, rise in general level of prices. Thus, central bank takes measures to reduce the credit creation capacity of the commercial banks during inflation. In turn, the money supply in an economy gets reduced and the inflationary gap or excess demand gets combated. Therefore, I would advocate contraction of money supply during excess demand.