Contractionary Monetary Policy Reduces Demand

Steps:

• Contractionary policy raises interest rates by reducing money supply.
• Higher interest rates increase borrowing costs for firms.
• This discourages investment spending.
• Lower investment reduces aggregate demand, slowing price increases and curbing inflation.

Why A is correct:

• Contractionary policy targets inflation by raising rates, which directly lowers investment via the interest rate channel in the IS-LM model.

Why the others are wrong:

• B: Investment falls, not rises, due to higher borrowing costs.
• C: Both investment and inflation fall, not rise, as policy cools the economy.
• D: Reduced demand from lower investment lowers, not raises, inflation.

Final answer: A