Final answer:
Contractionary monetary policy involves actions by the central bank to reduce the money supply, which leads to higher interest rates and a reduction of aggregate demand, thus decreasing both the price level and real GDP in the short term.
Step-by-step explanation:
Monetary policy that reduces the money supply is called a contractionary monetary policy. This type of policy is implemented by a central bank to decrease the amount of money and credit in the economy. As a result, the interest rate increases, which tends to discourage borrowing for investment and consumption. This shift in monetary policy leads to a leftward shift in aggregate demand, resulting in a lower price level and, in the short run, a decrease in real GDP. Tools like open market operations, through which the Federal Reserve sells bonds to reduce the money supply, and increasing the discount rate so banks borrow less, are ways to enact contractionary monetary policy.
During the 2008-2009 recession, central banks around the world also used quantitative easing in an opposite approach to expand the supply of credit, which is an example of expansionary monetary policy.