Contractionary Monetary Policy: Definition, Examples, Effects, Purpose, Tools

Contractionary monetary policy plays a very important role in the economic condition of a country. This is a type of monetary policy that is used to reduce the rate of monetary expansion. Usually, the central bank of a country uses a Contractionary monetary policy to fight inflation. This is a process to slow down the economic growth of a country. Inflation is very bad for the overall growth of a country’s economy because a rise in inflation indicates an overheated economy.

Key Takeaways

• The central bank can use the Contractionary monetary policy to increase the interest rates and put restrictions on the amount of money a bank can lend
• The most widely recognized successful contractionary monetary policy implementation happened in 1982 during the anti-inflationary recession caused by the Federal Reserve under the guidance of Paul Volcker
• The main purpose of contractionary monetary policy is to stop/reduce inflation
• “Increase the short-term interest rate” is the most commonly used contractionary monetary policy tools

What Is Contractionary Monetary Policy?

During the booming growth of the economy of a country, the central bank uses the contractionary monetary policy as a strategy to slow down the economy. In this type of situation, the central bank raises the interest rates which will make lending more expensive. So it will reduce the amount of money a bank can lend which results in a low money supply. When the central bank applies the contractionary monetary policy, loans, credit cards, and mortgages become more expensive.

Examples Of Contractionary Monetary Policy

There are not so many examples available on contractionary monetary policy because the policymakers want the economy to grow and inflation hasn’t been a problem since the 1970s. The most widely recognized successful contractionary monetary policy implementation happened in 1982 during the anti-inflationary recession caused by the Federal Reserve under the guidance of Paul Volcker. In the 1970s, the US economy was growing very fast which resulted in increasing inflation and unemployment. The inflation grew to exceed 10% because the Federal Reserve was keeping the interest rates too low. In January 1975, the federal bank dropped the interest rate to 7.5%. However, businesses didn’t lower the prices and the economic crisis was increasing rapidly. So when Paul Volcker became Fed Chair in 1979 he increased the interest rate to 20% and the inflation rate crashed all the way to 3.2% by mid-1983. However, the unemployment rate increased to 10% because companies had to renegotiate their debts and cut costs.     

Purpose Of Contractionary Monetary Policy

The main purpose of contractionary monetary policy is to stop/reduce inflation. If there is small inflation then there is nothing to worry about; for example, a 2% annual price increase is healthy for the economic growth of a country. Small inflation is also important because it stimulates demand therefore many central banks have an inflation target of around 2%. 

However, if inflation gets much higher than the 2% then it will start creating the problem. More than a 2% inflation rate will damage the economic growth of a country and people will start to buy too much now to avoid paying higher prices later. This type of situation will make the businesses produce more goods to meet the demand. If for any reason, businesses can’t able to produce more products then the price will increase rapidly and the total economic balance will be ruined.

This type of situation will create galloping inflation where the inflation is in double-digits. Moreover, if the situation continues then it might turn into hyperinflation, where prices rise 50% a month. So when inflation is on the rise, it is very important for the central bank to slow down the demand for products by making purchases more expensive. One of the simplest ways is to raise the bank lending rates. It will make the loans and home mortgages more expensive. Moreover, it will slow down inflation and returns the economy to a healthy growth rate of between 2% and 3%.

Tools For A Contractionary Monetary Policy

All contractionary monetary policy has the same set of tools. Some of the common and mostly used monetary policy tools are: 

1. Increase the short-term interest rate

2. Raise the reserve requirements

3. Expand open market operations              

Increase The Short-Term Interest Rate

Interest rate is the main tool for a contractionary monetary policy of a central bank because; most of the time, commercial banks take short-term loans from the central bank to meet the short-term liquidity shortage. Central banks usually charge a short-term interest rate for this type of loan. So the central bank can increase the short-term interest rate to reduce the money supply. Moreover, the increase of interest rate will also affect consumers and businesses because the commercial banks will also increase the interest rate when the central bank increases the interest rate.

Raise The Reserve Requirements

It’s a must for the commercial banks to hold the minimum amount of reserves with the central bank and a bank’s vault. So the central bank can increase the reserve requirements and it will decrease the money supply in the economy. So this is another excellent tool for the central bank to reduce inflation.    

Expand Open Market Operations

The central banks can expand open market operations to imply the contractionary monetary policy. Usually, the central bank is responsible for opening market operations by selling and purchasing government-issued securities. So the central bank can easily reduce the money circulating in the economy by selling large portions of the government securities to the investors.

Effects Of Contractionary Monetary Policy

Contractionary monetary policy has some excellent effects on the economy of a country. Some of the common effects are:

1. Reduced inflation

2. Slow down economic growth

3. Increased unemployment   

Reduced Inflation

One of the positive and most important effects of contractionary monetary policy is the reduction of inflation. In fact, it is the main target of a contractionary monetary policy. If the central bank can reduce the money supply in the economy then the policymakers will easily remove inflation and stabilize the prices in the economy.

Slow Down Economic Growth

When the central bank reduces the money supply it will slow down the economic growth. When the economy slows down, individuals and businesses stop investing big and the companies start to slow down the production. It will create a healthy balance in the economy.  

Increased Unemployment

This is a major side effect of contractionary monetary policy. Contractionary monetary policy increases the unemployment of a country. The economic slowdown and lower production is the main reason of unemployment.

FAQs About Contractionary Monetary Policy

References:

1. https://corporatefinanceinstitute.com/resources/knowledge/economics/contractionary-monetary-policy/
2. https://www.businessinsider.com/what-is-contractionary-monetary-policy
3. https://economictimes.indiatimes.com/definition/contractionary-policy