What is Contractionary Monetary Policy?
Contractionary monetary policy is the type of economic policy that is basically used to deal with inflation and it also involves minimizing the fund’s supply in order to bring an enhancement in the cost of borrowings which will ultimately lower the gross domestic product and moderate or decrease inflation too.
Explained in Detail
Let’s understand Contractionary Monetary Policy in detail.
It is a macroeconomic tool that is designed to combat monetary policy inflation which results from an expanding money supply in the economy, unreasonable asset valuation, and unsustainable speculation in the Stock Market.
Initially a contractionary monetary policy results in tightening of credit in the economy, increase unemployment, reduced borrowing by the private sector and reduced consumer spending resulting in an overall reduction in nominal gross domestic product (GDP), however, the goal is not to slow down economic growth but to make it more sustainable economic growth and a smoother business cycle over the medium to long-term period.
Monetary Authorities measure an economy’s long-term sustainable real growth rate also called the Real Trend rate. This Real Trend rate is difficult to observe directly and is required to be estimated. Further, the trend rate also changes over time as the structural condition of the economy changes and such structural changes in the economy reduce the trend growth rate of the economy. (Structural condition refers to changes in the saving and investment pattern in an economy, for instance, consumer shift from the use of heavy debt to increase saving and reduction in consumption).
Neutral Interest Rate = Real Trend Rate + Inflation Target
Where Neutral Interest Rate is the growth rate of the money supply that neither increases nor decreases the economic growth rate.
When the policy rate is above the neutral interest rate, the monetary policy is said to be a Contractionary Monetary Policy. By setting the policy rate above the neutral interest rate, the growth rate of the money supply is decreased. Central Bank influences interest rates by expanding or contraction of the monetary base, which is the currency in circulation and banks’ reserves (CRRCRRCash Reserve Ratio refers to the share of a Bank’s total deposits that need to be maintained with the respective Country’s Central Bank to control financial supply in the economy. and SLR) on deposits at the central bank.
Contractionary Monetary Policy Tools
These are the three main tools that are used by Central Bank to implement the Contractionary Monetary Policy:
- Open Market Operations: Buying and selling of government securities by the central bank (in the case of India, Reserve Bank of India) is referred to as 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.. Under this, central bank influences interest rates by selling government debt in the market which results in reduced cash in investor account, excess reserves with banksExcess Reserves With BanksExcess reserves are kept or deposited with the central regulatory authority over and above the statutory requirements. If reserves are positive, the bank has held the amount in reserves more than the statutory requirement. In the case of zero value, there is no deficit or surplus reserves balance kept., fewer funds available for lending and reduced money supply thereby sucking liquidity from the system and led to tightening of the amount of money in circulation. However, it is pertinent to note that in the absence of a liquid market in government debt securities it is difficult to implement open market operations.
- Reserve Requirements: Banks are required to keep a certain amount of reserves with Central Bank in the form of CRR and SLR. 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., the central bank effectively decreases the funds that are available for lending and the money supply which further led to an increase in interest rates.
- Policy Rate: Policy rate is basically the monetary tool used by the Central bank to control the money supply in the country. Prominent Policy rates are Repo Rate and Reverse Repo RateRepo Rate And Reverse Repo RateRepo Rate is the rate at which the commercial banks of a particular country borrow money from the central bank of that country, as and when required. whereas, Reverse Repo Rate is the rate at which the central bank borrows back money from other commercial banks, in order to control the money supply in the markets.. Repo Rate is the rate at which central bank lends money to Banks and Reverse Repo rate is the rate at which central bank borrows funds from the banks. By increasing the repoRepoA repurchase agreement or repo is a short-term borrowing for individuals who deal in government securities. Such an agreement can happen between multiple parties into three types- specialized delivery, held-in-custody repo and third-party repo. rate as part of contractionary monetary policy implement exercise, the central bank makes the cost of borrowing high for banks which in turn compel banks to increase their lending rates resulting in the reduced supply of money.
Monetary Policy is often adjusted to reflect the source of inflation. Contractionary Monetary Policy is an appropriate response to combat inflation if inflation is above the target inflation (determined by Central Bank) caused due to higher aggregate demandAggregate DemandAggregate Demand is the overall demand for all the goods and the services in a country and is expressed as the total amount of money which is exchanged for such goods and services. It is a relationship between all the things which are bought within the country with their prices. (i.e. higher consumer spending and business investments), however, the same contractionary monetary policy can result in serious ramification to the economy if it is implemented in such a case where monetary policy inflation is higher due to supply shocks (i.e. higher food and essential commodityCommodityA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units. prices) and an economy which is operating below full employment level.
The idea behind implementing a contractionary monetary policy is to make the opportunity cost of holding funds high so that people save more and spend less. Discouraging consumer spending by increasing interest rates helps in combating the monetary policy inflation as it results in reduced demand but can also lead to increased unemployment due to less capital investmentCapital InvestmentCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc. by the business due to tighter money supply and high-interest rates. Thus we can say that the effectiveness and success of the Contractionary monetary policy depend upon the consumer spending and investment pattern of the economy and execution capability of the central bank of that country.
Contractionary Monetary Policy Video
This has been a guide to Contractionary Monetary Policy. Here we discuss Contractionary Monetary Policy tools (open market operations, changes in reserve requirements, policy rate) along with practical examples. You may learn more about Economics from the following articles –