Contractionarymonetary policyis when acentral bankuses its monetary policy tools tofight inflation.It's how the bank slowseconomic growth. Inflation is a sign of an overheated economy. It's also calleda restrictive monetary policy because it restricts liquidity.
The bank will raise interest ratesto make lending more expensive.That reducesthe amount of money and credit thatbankscan lend. It lowersthemoney supplyby making loans, credit cards, and mortgages more expensive.
Purpose of Monetary Policy
The purpose of a restrictive or tight monetary policy is to ward off inflation. A little inflation is healthy. A 2%annual price increase is actually good for the economy because it stimulatesdemand. People expect prices to be higher later, so they may buy more now. That's why many central banks have aninflation targetof around 2%.
Ifinflation gets much higher, it'sdamaging. People buy too much now to avoid paying higher prices later. This consumer buying may cause businesses to produce more to take advantage of higher demand. If they can't produce more, they'll raise prices further. They may take on more workers. Now people have higher incomes, so they spend more. It becomes a vicious cycle if it goes too far. It creates galloping inflation where inflation is in the double-digits. Even worse, it can result inhyperinflation, where prices rise 50% a month.
To avoid this, central banksslow demand by making purchases more expensive. They raise bank lending rates. That makes loans and home mortgages more expensive. It cools inflation and returns the economy to ahealthy growth rateof between 2% and 3%.
The U.S. central bank is theFederal Reserve. It measures inflation usingthecore inflationrate. Core inflation isyear-over-yearprice increasesminusvolatilefood andoil prices. TheConsumer Price Index (CPI)is the inflation indicator most familiar to the public. The Fed prefers thePersonal Consumption Expenditures Price Index. It uses formulas that smooth out more volatility than the CPI does.
If the PCE Index for core inflation rises much above 2%, then the Fed implements contractionary monetary policy.
How Central Banks Implement Contractionary Policy
Central banks have lotsofmonetary policy tools. The firstisopen market operations. Here's how the Federal Reserve tools are used in the U.S.
TheFed is the official bankfor the federal government. The government deposits U.S. Treasury notesat the Fed like you deposit cash. To implement a contractionary policy, the Fed sells these Treasurysto its member banks. The bank must pay the Fed for the Treasurys, reducing the credit on its books. As a result, banks have less money available to lend. With less money to lend, they charge a higher interest rate.
The opposite of restrictive open market operations is calledquantitative easing. That's when the Fed buys Treasurys,mortgage-backed securities,or bonds from its member banks. It is an expansionary policy because the Fed simply creates the credit out of thin air to purchase these loans. When it does this,the Fed is “printing money.”
The Fed can also raise interest rates by using its second tool, thefed fundsrate. It's the rate thatbankscharge each other to borrow funds to meet thereserve requirement. The Fed requires banks to have a specificreserve on hand each night. For most banks, that's 10% of their total deposits. Without this requirement, banks would lend out every single dollar people deposited. They wouldn't have enough cash in reserve to cover operating expenses if any of the loans defaulted.
The Fed raises the fed funds rate to decreases themoney supply. Banks charge higherinterest rateson their loans to compensate for the higher fed funds rate. Businesses borrow less, don't expand as much, and hire fewer workers. That reducesdemand. As people shop less, firms slash prices. Falling prices putan end to inflation.
The Fed's third tool is the discount rate. That's what it charges banks who borrow funds from the Fed'sdiscount window. Banks rarely use the discount window, even though the rates are usually lower than the fed funds rate. That's because other banks assume the borrowing bank must be weak since it is forced to use the discount window. In other words, banks hesitate to lend to those banks who borrow from the discount window.The Fed raises the discount rate when it raises the target for the fed funds rate.
The Fed rarely uses its fourth tool, increasing the reserve requirement. It'sdisruptive for banks to changeprocedures and regulations to meetanewrequirement. Raising the fed funds rate is easier and achieves the same aim.
Effects and Examples
Higher interest rates make loans more expensive. As a result, people are less likely to buy houses, autos, and furniture. Businesses can't afford to expand. The economy slows. If not exercised with care, the contractionary policycan push the economy into arecession.
There aren't many examples of contractionary monetary policy for two reasons. First, the Fed wants the economy to grow, not shrink. More importantly, inflation hasn't been a problem since the 1970s.
In the 1970s, inflation grew to exceed 10%. In 1974, it went from 4.9% in January to 11.1% in December. The Fedraisedinterest rates to almost 13% by July 1974. Despite inflation, economic growth was slow. That situation is calledstagflation. The Fed responded to political pressure and dropped the rate to 7.5% in January 1975.
Businesses didn'tlower prices when interest rates went down. They didn't know when the Fed would raise them again. AfterPaul Volcker became Fed Chairin 1979, the fed funds rate increased to a peak of 20% in 1981. He kept it there, finally putting a stake through the heart of inflation.
FormerFed Chair Ben Bernankesaid contractionary policy caused theGreat Depression. The Fed had instituted contractionary monetary policies to curb thehyperinflationof the late 1920s. During the recession orstock market crash of 1929, it didn’t switch to expansionary monetary policy as it should have. It continued contractionary policy and raised rates.
It did so because thegold standard backed the dollars. The Fed didn't want speculators to sell their dollars for gold and deplete theFort Knoxreserves. Anexpansionary monetary policywould have created a little healthy inflation. Instead, the Fed protected the dollar's value and created massivedeflation. That helped turn a recession into a decade-long depression.
How Contractionary Differs From Expansionary Policy
Expansionary monetary policy stimulates the economy. The central bank uses its tools to add to themoney supply. It often does this byloweringinterest rates. It can also use expansionary open market operations, calledquantitative easing.
The result is an increase in aggregate demand. It boostsgrowth as measured bygross domestic product.It lowers the value of the currency, thereby decreasing the exchange rate.
Expansionary monetary policy deters thecontractionary phaseof thebusiness cycle, but it is difficult for policymakers to catch this in time. As a result, you'll often see the expansionary policy used after arecessionhas started.
Frequently Asked Questions (FAQs)
Under what scenario would the Federal Reserve sell bonds as part of a contractionary policy?
The Federal Reserve sells Treasury bonds on its balance sheet when uncomfortably high inflation threatens price stability. The Fed can also choose to "roll off" bonds by letting them mature and keeping the returned principal rather than reinvesting it into a new bond (a Treasury "rollover").
What are the benefits of contractionary monetary policy?
A direct benefit of contractionary monetary policy is that it strengthens government budgets. For example, when the Fed's discount rate increases, the government earns more money from the banks that borrow funds from the Fed's discount window. The government can use this source of revenue to offset spending and decrease budget deficits.
