Even if the banks are fully loaned up, they can obtain additional reserves by selling T-bills, by issuing bank deposit notes, by conducting repurchase agreements with their depositors, or by borrowing in the eurodollar market or at the discount window. With these new reserves,the banks can further expand the money supply. As income decreases, the money demand function also decreases, from M d0 to M d2 . This situation occurs during an contraction when income is decreasing. Economic participants need less money to support fewer and smaller purchases.
Economic participants repay their debt.
When economic participants repay their debt, the volume of bank loans goes down and the money supply contracts from M s0 to M s2 . If monetary policy is to be effective in stimulating an economy during a contraction or slowing it down during an expansion, then the demand for spending must be sensitive to small changes in interest rates. Stimulating an Economy During a Contraction During an expansion, increases in spending pull up interest rates. With each increase in interest rates, spending becomes more senstive to additional increses. When the central bank attempts to slow the expansion by increasing interest rates, the additional increases causes spending to fall off significantly.