When a central bank uses its monetary policy tools to combat inflation, this is known as contractionary monetary policy. It's the bank's method of stifling economic growth. Inflation is a symptom of a swollen economy. Because it restricts liquidity, it's also known as a restrictive monetary policy. To make lending more expensive, the bank will raise interest rates. The amount of money and credit that banks can lend is reduced as a result. It reduces the money supply by raising the cost of loans, credit cards, and mortgages.
Monetary Policy's Goals
A restrictive or tight monetary policy aims to keep inflation at bay. A small amount of inflation is beneficial. A 2% annual price increase is beneficial to the economy because it increases demand. People anticipate higher prices in the future, so that they may purchase more now. As a result, many central banks set an inflation target of around 2%. It will be harmful if inflation rises significantly. People purchase excessive amounts of goods now in order to avoid paying higher prices later. Because of the increased demand, businesses may produce more in order to meet it. They'll raise prices even more if they can't produce more. They might hire more people. People now have more disposable income, so they spend more. If it gets out of hand, it becomes a vicious cycle. When inflation is in the double digits, it causes galloping inflation. Worse, it can lead to hyperinflation, in which prices rise by 50% in a month. To avoid this, central banks stifle demand by raising the cost of purchases. They raise the interest rates on bank loans. This raises the cost of loans and mortgages. It lowers inflation and restores the economy's healthy growth rate of 2% and 3%. The Federal Reserve is the United States' central bank. The core inflation rate is used to calculate inflation. Year-over-year price increases are subtracted from volatile food and oil prices to calculate core inflation. The Consumer Price Index (CPI) is the most widely used inflation indicator. The Fed prefers the Personal Consumption Expenditures Price Index. It employs formulas that smooth out higher levels of volatility than the CPI. When the PCE Index for core inflation rises significantly above 2%, the Fed adopts a contractionary monetary policy.Contractionary Policy Implementation by Central Banks
Central banks have a wide range of monetary policy tools at their disposal. Open market operations are the first. In the United States, the Federal Reserve's tools are used in the following ways. The Federal Reserve is the government's official bank. U.S. Treasury notes are deposited at the Fed the same way cash is deposited. The Fed sells these Treasurys to its member banks to implement a contractionary policy. The bank will have to pay the Fed for the Treasurys, which will reduce the amount of credit it has on its books. As a result, banks are unable to lend as much money. They charge a higher interest rate because they have less money to lend. Quantitative easing is the polar opposite of restrictive open market operations. This is known as quantitative easing when the Fed buys Treasurys, mortgage-backed securities, or bonds from its member banks. Because the Fed creates credit out of thin air to purchase these loans, it is an expansionary policy. The Fed is "printing money" when it does this. The Fed can also use its second tool, the fed funds rate, to raise interest rates. It's the interest rate at which banks lend money to each other to meet reserve requirements. Each night, the Fed requires banks to have a specific reserve on hand. For most banks, that equates to 10% of total deposits. Banks would lend out every dollar deposited if this requirement did not exist. If any of the loans defaulted, they wouldn't have enough cash on hand to cover operating expenses. To reduce the money supply, the Fed raises the Fed funds rate. Banks charge higher interest rates on their loans to compensate for the higher fed funds rate. Businesses take out fewer loans, expand less, and hire fewer people. This lowers demand. Firms slash prices as people shop less. Inflation was brought to a halt by falling prices. The discount rate is the Fed's third tool. That's how much it costs banks to borrow money from the Federal Reserve's discount window. Despite the fact that rates are typically lower than the fed funds rate, banks hardly ever use the discount window. Because the borrowing bank is forced to use the discount window, other banks assume the borrowing bank is weak. To put it another way, banks are hesitant to lend to banks that borrow from the discount window. When the Fed raises the fed funds rate target, it also raises the discount rate. The Fed's fourth tool, raising the reserve requirement, is rarely used. Changing procedures and regulations to meet the new requirement is disruptive for banks. Raising the federal funds rate is less difficult and accomplishes the same goal.Examples and Effects
Loans become more expensive as interest rates rise. As a result, fewer people are purchasing homes, automobiles, and furniture. Businesses are unable to expand due to financial constraints. The economy is slowing down. Contractionary policy, if not used carefully, can push the economy into a recession. For two reasons, there aren't many examples of contractionary monetary policy. First and foremost, the Fed wants the economy to expand rather than contract. More importantly, since the 1970s, inflation has not been an issue. Inflation reached a high of 10% in the 1970s. It jumped from 4.9 percent in January to 11.1 percent in December of 1974. By July 1974, the Fed had raised interest rates to nearly 13%. Despite inflation, the economy grew slowly. Stagflation is the term for this situation. In January 1975, the Fed responded to political pressure by lowering the rate to 7.5 percent. When interest rates fell, businesses did not lower their prices. They had no idea when the Fed would raise interest rates again. The fed funds rate rose to a high of 20% in 1981 after Paul Volcker became Fed Chair in 1979. He kept it there, finally driving a stake through inflation's heart. Former Federal Reserve Chairman Ben Bernanke claimed that contractionary policy was to blame for the Great Depression. To combat the late-twentieth-century hyperinflation, the Fed implemented contractionary monetary policies. It did not switch to expansionary monetary policy as quickly as it should have during the 1929 recession or stock market crash. It maintained its contractionary policy while raising interest rates. It was able to do so because the dollar was backed by gold. The Fed didn't want speculators to sell their dollars for gold, depleting the reserves at Fort Knox. A little healthy inflation would have resulted from an expansionary monetary policy. Instead, the Fed protected the value of the dollar by inducing massive deflation. This aided in the transformation of a recession into a decade-long depression.What Is the Difference Between Contractionary and Expansionary Policy?
The economy is stimulated by expansionary monetary policy. To increase the money supply, the central bank employs its tools. This is frequently accomplished by lowering interest rates. It can also use quantitative easing or expansionary open market operations. As a result, aggregate demand increases. It improves gross domestic product (GDP) growth. It decreases the exchange rate by lowering the currency's value. The contractionary phase of the business cycle is stifled by expansionary monetary policy, but policymakers have a hard time detecting it in time. As a result, the expansionary policy is frequently used after a recession has begun.Most Commonly Asked Questions (FAQs)
In what circumstances would the Federal Reserve sell bonds as part of a contraction policy?
When uncomfortably high inflation threatens price stability, the Federal Reserve sells Treasury bonds on its balance sheet. The Fed can also choose to "roll off" bonds by allowing them to mature and keep the money instead of reinvesting it in new bonds (a Treasury "rollover").What are the advantages of a tightening monetary policy?
Contractionary monetary policy has the direct benefit of strengthening government budgets. When the Federal Reserve's discount rate rises, for example, the government earns more money from banks borrowing funds from the Fed's discount window. The government can use this source of revenue to offset spending and reduce budget deficits.