Tightening Monetary Policy to Curb Inflation

Steps:

• Higher interest rates increase borrowing costs, reducing consumer and investment spending to lower demand-pull inflation.
• Lower money supply decreases available funds for spending, easing inflationary pressures via quantity theory of money (MV = PQ).
• Higher exchange rate appreciates the currency, making imports cheaper and reducing cost-push inflation from higher input prices.
• Combined, these reduce aggregate demand and costs, leading to lower overall inflation.

Why B is correct:

• Aligns with contractionary monetary policy, where higher rates and lower money supply slow money velocity and demand (per MV = PQ), while exchange rate appreciation cuts import costs.

Why the others are wrong:

• A: Lower exchange rate raises import prices (cost-push inflation); higher money supply fuels demand-pull inflation, outweighing higher rates.
• C: Lower interest rates boost spending and demand-pull inflation, countering benefits of higher exchange rate and lower money supply.
• D: Lower exchange rate and higher money supply both increase costs and demand, while lower rates amplify spending for higher inflation.

Final answer: B