Final answer:
A recent reduction in the money supply often results in higher interest rates, leading to decreased borrowing and potential slowdowns in sectors like business investment, home construction, and car manufacturing, possibly inciting a recession.
Step-by-step explanation:
When an economy is adjusting to a recent reduction in the money supply, a likely consequence is the increase in interest rates. This in turn discourages borrowing for investment and consumption spending. As borrowing becomes less attractive, sectors that rely heavily on loans, such as business investment, home construction, and car manufacturing, may see a decline in activity. The reduced accessibility to loans can result in a contractionary effect on the economy, leading to an aggregate demand decline, which can potentially trigger a recession.
Examining the 2008-2009 Great Recession illustrates the detrimental impact when banks, under financial stress due to a decline in the value of their assets, are less able to provide loans. This can cause a significant contraction in the economy, exacerbating the effects of the reduced money supply. As a contractionary monetary policy can be deliberately implemented to cool down an economy that is overproducing relative to its potential GDP, it tends to adjust output levels to more sustainable levels, potentially reducing inflationary pressures.
Therefore, in response to a contractionary monetary policy, businesses and consumers may find credit more expensive and less available, which could lead to lower levels of economic activity.