Final answer:
Contractionary monetary policy decreases economic output by raising interest rates, which discourages borrowing, reduces aggregate demand, and results in a lower price level and real GDP.
Step-by-step explanation:
Contractionary monetary policy is employed by central banks, like the Federal Reserve, to address inflationary pressures arising from an economy operating beyond its potential GDP. The process involves the central bank raising interest rates, making borrowing more costly. Elevated interest rates discourage both consumer spending and business investment, reducing overall borrowing.
As borrowing declines, aggregate demand contracts, leading to a leftward shift in the aggregate demand curve. This shift results in a decrease in the price level and a contraction in real GDP. The ultimate effect is a slowdown in economic output, aiming to bring the economy back to a sustainable level and mitigate inflationary pressures. Contractionary monetary policy acts as a tool for central banks to navigate economic cycles and maintain price stability while balancing growth objectives.