Contractionary Monetary Policy

Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Contractionary Monetary Policy?

A contractionary monetary policy refers to the initiatives the central banks take to control the monetary expansion, likely to lead to inflation. These policies are framed to put necessary restrictions and limit borrowing for businesses and spending for consumers.

What Is A Contractionary Monetary Policy

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The contractionary policy puts monetary restrictions in place for the nations to abide by so that the economy remains stable and fights against unwanted financial scenarios. As a result of compliance, the money supply to the market gets limited, thereby taking control of unsustainable economic conditions due to inflation.

Key Takeaways

  • Contractionary monetary policy is an economic policy used to deal with inflation. 
  • It involves reducing the money supply to ensure the cost of borrowing is high enough to restrict people from applying for a loan.
  • It is a macroeconomic tool designed to combat inflation resulting from an expanding money supply in the economy, unreasonable asset valuation, and unsustainable speculation in the stock market.
  • Open market operations, increased interest rates, and increased reserve requirements are three tools that help central banks implement contractional measures to control the economy.

How Does Contractionary Monetary Policy Work?

The contractionary monetary policy definition specifies the monetary control measures the authorities impose to take care of economic disruptions effectively. The central banks of respective economies facilitate these, especially to deal with inflation, which results from an expanding money supply in the economy, unreasonable asset valuation, and unsustainable speculation in the stock market. While inflation is good for the economy as it controls the borrowing frequency and customer spending, the scenario turns adverse if the level moves to a considerable high.

When the contractionary policy is introduced, the borrowing criteria get stricter. It is an intentional move by the federal banks so that the businesses do not feel feasible to apply for loans. The objective of the contractionary monetary policy is to make borrowing for businesses an infrequent affair. This, in turn, diminishes the pace of the market, thereby hampering the money supply.

In addition to restricting the borrowing frequency, the central banks aim to control customer spending. When the money supply gets limited, the citizens are left with less money to invest in luxury items. All they think of is spending on basic and necessary items. As the money movement gets restricted, it binds to unreasonable asset valuation. It keeps control over the stock market and investment industry, thereby ensuring the effects of inflation on an economy turn null and void.

Though it is difficult to control the inflation effects completely, these policies help deteriorate it greatly showing the positive impact of contractionary monetary policy.

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Contractionary Monetary Policy Explained in Video

Tools

The tools that the central banks use to make these policies effective are – open market operations, increased reserve requirements, and increased interest rates.

Contractionary Monetary Policy Tools

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#1 – Open Market Operations

The first tool that the central banks use is open market operationsOpen Market OperationsAn Open Market Operation or OMO is merely an activity performed by the central bank to either give or take liquidity to a financial institution. The aim of OMO is to strengthen the liquidity status of the commercial banks and also to take surplus liquidity from them.read more. Federal Reserve, the nation’s central bank, is where the government deposits Treasury notes in the United States. It is similar to how citizens make cash deposits to normal national banks. When the central bank decides to implement the contractionary policy, it starts selling the bonds to the member banks, which pay the former for the purchases.

As the latter starts paying, it runs short of cash to lend to the loan seekers. Hence, it charges higher interest rates, which is not possible for everyone to agree to. This puts restrictions on the borrowing frequency in the nation which are the benefits of contractionary monetary policy.

#2 – Increased Reserve Requirements

Banks must keep a significant reserve with the central bank. By increasing the reserve requirementReserve RequirementReserve Requirement is the minimum liquid cash amount in a proportion of its total deposit that is required to be kept either in the bank or deposited in the central bank, in such a way that the bank cannot access it for any business or economic activity.read more, the central bank effectively decreases the funds available for lending and restricts the money supply, increasing the contractionary monetary policy interest rates. Hence, reserve requirements serve as the next of the list tools central banks use to make such policies effective.

#3 – Increased Interest/Discount Rate

The Fed increases the discount rate at which it offers funds to the member banks. However, banks hardly opt for the discount window borrowing option despite the interest rates being lower than the usual rate of interest charged for Fed funds. Banks avoid this option because taking up loans from a discount window might hamper their image. The customers might think the banks are not financially sound, so they opt for the discounted interest rate. The banks ignore it to maintain their market reputation. However, the trick of the Fed here is that it increases the discount rate when it desires to raise the interest rate for the Fed funds to restrict the money supply.

Effects

A contractionary policy results in a tightening of credit criteria in the economy, increased unemployment, reduced private-sector borrowings, and reduced consumer spending. This results in an overall reduction in the nominal gross domestic productNominal Gross Domestic Product (GDP)Nominal GDP (Gross Domestic Product) is the calculation of annual economic production of the entire country's population at current market prices of goods and services generated by four main sources: land appreciation, labour wages, capital investment interest, and entrepreneur profits calculated only on finished goods and services.read more (GDP). However, the goal is not to slow down economic growth but to make it more sustainable and achieve a smoother business cycle over the medium to long-term period.

Contractionary Monetary Policy Effects

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The monetary authorities measure an economy’s long-term sustainable real growth rate, called the real trend rate. However, this real trend rate is challenging to observe directly and must be estimated. Further, the trend rate also changes over time as the structural condition of the economy changes, reducing the growth rate trend, which clearly shows the impact of contractionary monetary policy.

Graph

Let us look at the contractionary monetary policy diagram to understand the concept.

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In the above diagram, the original equilibrium level is E2, which is the economy’s potential GDP, and experiencing the pressure of inflation. In such a case, a contraction in the monetary policy through rise in interest rate will bring about a control on the consumer spending and investment. This will result in fall in demand from D1 to D2. At the same time, the equilibrium level will come down to E1. Thus, we see from the above contractionary monetary policy diagram that the policy successfully able to control the inflationary situation in the economy.

Examples

Let us consider the following contractionary monetary policy examples to understand how it works:

Example #1

The central bank of nation A observed an increase in the inflation rate to 2%. It indicated a stable economy. However, the level kept rising and became a major concern, with the data showing an increase of 10% in the inflation rate. This was when the central bank started selling government securities to member banks. As a result, the remaining banks in the nation ran short of funds and hence, increased the contractionary monetary policy interest rates on borrowing, restricting the money supply in the market to take immediate control of the situation.

Example #2

recent report indicated inflation in the energy, food, and commodities markets. It advocated the need for the central banks to increase the interest rate beyond the neutral figures, intending to introduce contractionary monetary policy before the economies worldwide get affected. Though the expected economic disruption is yet to take its structural form and lead to disinflation and deflation on the go, the authorities are planning to take stricter steps beforehand.

Pros & Cons

While the benefits of contractionary monetary policy are in many ways, there are a few challenges that it comes up with. So let us have a look at the advantages and disadvantages of the initiative:

helps an economy be stable, there are a few challenges that it comes up with. Let us have a look at the advantages and disadvantages of the initiative:

ProsCons
Maintains economic stabilityMight lead to a recession
Prevents inflationLower production
Decreases rate of demandA rise in the unemployment rate
Aims to ensure price stability 

Contractionary Monetary Policy Vs Expansionary Monetary Policy

Contractionary and expansionary policies are initiatives that governments consider to tackle two different economic conditions. Let us check out some of the differences between these two policies:

  • A contractionary policy attempts to control a situation by slowing down the economy. In contrast, an expansionary policy is an effort that central banks put in to accelerate an economy.
  • The former is an answer to an inflationary economy, while the latter works well for a receding one.
  • Under the contractionary policy, the interest rates of central banks increase to limit the money supply. This restricts borrowers from borrowing and customers from spending. On the contrary, the expansionary policy is introduced with the central banks decreasing the interest rate to improve the money supply. It encourages individuals and entities to borrow more and customers to spend more.

Frequently Asked Questions (FAQs)

When is a contractionary monetary policy used?

The central banks introduce it within an economy as and when the threat of inflation appears to hit the respective nations. It is a measure that helps control the money supply in a nation so that the borrowing frequency decreases while restricting the customers from spending more. This control over borrowing and expenditure helps fight inflation by slowing down economic activities.

How does contractionary monetary policy reduce inflation?

This policy reduces inflation by restricting the supply of funds from multiple banks across a particular nation. When the central banks increase the interest rate on the government bonds and securities, the member banks buy those securities but, in turn, run short of funds. As a result, they do not have funds to lend. Thus, they increase the interest rate on borrowing, making it difficult for borrowers to apply for loans.

Why is contractionary monetary policy rarely used?

This policy is rarely used as it leads to recession while tackling inflation. The worst side-effect of taking this initiative is to be ready to witness a high rise in the unemployment rate.

This has been a guide to what is Contractionary Monetary Policy. We explain it with example, graph, differences with expansionary monetary policy & effects. You may learn more about Economics from the following articles –

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