A contractionary monetary policy is a type of monetary policy that is intended to reduce the rate of monetary expansion to fight inflation. A rise in inflation is considered the primary indicator of an overheated economy, which can be the result of extended periods of economic growth. The policy reduces the money supply in the economy to prevent excessive speculation and unsustainable capital investment.
A contractionary monetary policy is generally undertaken by a central bank or a similar regulatory authority. The central bank usually sets a target for the inflation rate and uses the contractionary monetary policy to meet the target.
Tools for a Contractionary Monetary Policy
Every monetary policy uses the same set of tools. The main tools of monetary policy are short-term interest rates, reserve requirements, and open market operations. A contractionary monetary policy utilizes the following variations of these tools:
1. Increase the short-term interest rate (discount rate)
Interest rates are the primary monetary policy tool of a central bank. Commercial banks can usually take short-term loans from the central bank to meet short-term liquidity shortages. In return for the loans, the central bank charges the short-term interest rate.
In order to reduce the money supply, the central bank can opt to increase the cost of short-term debt by increasing the short-term interest rate. The increase in interest rates will also affect consumers and businesses in the economy as commercial banks will raise the interest rates they charge their clients.
2. Raise the reserve requirements
Commercial banks are obliged to hold the minimum amount of reserves with the central bank and a bank’s vault. A rise in the required reserve amount would decrease the money supply in the economy.
3. Expand open market operations (sell securities)
The central bank is involved in open market operations by selling and purchasing government-issued securities. The central bank can reduce the money circulated in the economy by selling large portions of the government securities (e.g., government bonds) to investors.
Effects of a Contractionary Monetary Policy
A contractionary monetary policy may result in some broad effects on an economy. The following effects are the most common:
1. Reduced inflation
The inflation level is the main target of a contractionary monetary policy. By reducing the money supply in the economy, policymakers are looking to reduce inflation and stabilize the prices in the economy.
2. Slow down economic growth
Reducing the money supply usually slows down economic growth. As the money supply in the economy decreases, individuals and businesses generally halt major investments and capital expenditures, and companies slow down their production.
3. Increased unemployment
An unwanted side effect of a contractionary monetary policy is a rise in unemployment. The economic slowdown and lower production cause companies to hire fewer employees. Therefore, unemployment in the economy increases.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)® certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful: