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What is Contractionary Monetary Policy?

Contractionary Monetary Policy is a macroeconomic policy, like reducing expenditure or raising the interest rate to reduce the GDP and counter the effect of inflation.

For example, the Federal Reserve began hiking interest rates to combat stubbornly high inflation, which touched 9.1% in June 2023. It, in turn, will lead to lowered spending, and thus, product recess will decline over time.

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Key Highlights

Contractionary monetary policy is a strategy a country’s central bank adopts to slow the economy and manage increasing inflation during periods of rapid growth or other economic distortions

The Federal Reserve’s policy consists of three primary fiscal measures: selling government securities, interest rates hikes, and the bank’s reserve requirement increment

The policy’s fundamental goal is to limit the money supply, which it accomplishes by increasing the cost of credit cards, loans, and mortgages.

How Does Contractionary Monetary Policy Work?

Examples Example #1

Inflation skyrocketed in the early 1970s. To control inflation, the Fed hiked interest rates from 9.4 to 11.0 from January to December 1974. As a result, inflation in 1976 fell to 5.8%. However, the OPEC energy crisis ruined the party, and inflation reached 14% in 1980. As a result, the Federal Reserve raised interest rates to 13.5% in 1980. The policy reversed the price trend, lowering inflation to 3.2% in 1983.

Example #2

President Bill Clinton used contractionary policy in 1993 as the Deficit Reduction Act and the Omnibus Budget Reconciliation Act of 1993. He increased the income taxes for various income brackets, added taxes for high-income earners in their Social Security benefits, ended some corporate subsidies, and provided tax credits. Finally, he raised the tax on gas by 4.3 cents per gallon, making it more challenging for corporations to get deductions on their entertainment tax.

Example #3 Effects Lower Inflation

The primary goal of CMP implementation is to tame hyperinflation in the economy. Because of policy execution, there is less money to lend to banks.

As capital flows diminish, demand for goods and services declines, resulting in low inflation.

Reduces Government Debt

The contractionary policy also helps to minimize the government’s fiscal deficit and national debt.

Contractionary policy, for example, resulted in the United States government going from significantly in debt to a budget surplus during Bill Clinton’s presidency from 1993 to 2001.

Slower Economic Growth

Higher interest rates have a significant impact on economic activity.

Most companies and individuals postpone or cancel their expansion plans.

Economic growth becomes sluggish as noticeable amounts of investments and capital expenditures in public and private sectors draw to a halt.

Higher Unemployment

The rise in the unemployment rate is one of the negative consequences of contractionary policies.

More individuals are unemployed as corporations and small businesses lay off employees or cancel expansion plans.

For example, the unemployment rate in the United States reached 3.7% in October and will deteriorate to 4.5% in 2023 due to monetary tightening policy decisions.

Tools Increasing Federal Fund Rates (FFR)

The Federal Reserve raises the fed fund rate during a contractionary policy.

These are the overnight borrowing rates that banks charge each other to satisfy their reserve requirements.

Increasing Short-Term Interest Rates (Discount Rates)

Commercial banks borrow short-term loans from the central bank at discount rates to cover short-term liquidity shortfalls.

The central bank can restrict the money supply by increasing the cost of short-term loans by raising the short-term interest rate.

Increase Reserve Requirements

Commercial banks must keep a portion of their deposits with the central bank to fulfill liabilities in the case of unexpected withdrawals.

It is one method through which the central bank regulates the money supply in the economy.

Therefore, raising the reserve requirement hinders commercial banks from lending to the general people.

Selling Government Securities

The Fed sells government-issued securities to commercial institutions through open market transactions.

When banks buy T-bonds and bills, it signals that they have lesser funds to lend.

As a result, the amount of money in circulation decreases.

Final Thoughts

During the economic growth cycle, inflation rises and exceeds the safe zone of 2%. It is a sign of an overheating economy that makes introducing a contractionary monetary policy compulsory. The Fed uses monetary instruments in an attempt to tighten the money supply. The policy implementation makes Loans, commodities, and services more costly. As a result, consumer demand and expenditure fall, resulting in low inflation.

Frequently Asked Questions (FAQs) Q2. How does contractionary monetary policy affect the stock market?

Answer: When governments employ contractionary monetary policies, it affects a business’ future valuation. As a result, the specific firms face a drop in stock prices. Thus, these policies affect the stock market negatively and may lead to losses for public companies. However, we also see that this effect only lasts for a short time, and the price of shares may return to normal over time.

Q3. What are the steps in contractionary monetary policy? Q4. When was a contractionary monetary policy used?

Answer: The Contractionary policy came into action in the 1980s when Paul Volcker, the then-Federal Reserve chair, ended the soaring inflation of the 1970s. The federal fund interest rates peaked at 20% in 1981. The Measured inflation levels fell to 3.2% in 1983 from 14% in 1980.

Q5. Why do interest rates rise as a result of monetary policy?

Answer: The tightening of the money supply due to monetary policy results in less cash accessible to banks. With reduced capital supply, financial institutions raise interest rates on all services like credit cards, mortgages, auto loans, etc.

Q6. What effect does the contractionary policy have on exports? Recommended Articles

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