Contractionary monetary policy is used during an inflationary gap to slow economic growth, primarily to combat inflation.
During an inflationary gap, the economy is in short-run equilibrium with output higher than the full employment level. The main consequence of this circumstance is inflation (a sustained increase in the level of commonly bought goods and services) at levels higher than desired. High inflation can occur, for example, when unemployment is low and the economy is growing rapidly. An unusual increase in population might lead to a period in which the demand for goods is so high that supply is insufficient. The goal of any policy intervention during an inflationary gap is to decrease aggregate demand and slow the economy until the equilibrium output (real GDP) reaches full employment levels. In the event of a inflationary gap, intervention in the economy called a contractionary monetary policy may be implemented through central bank actions with the goal of decreasing economic growth. These actions can be used to decrease aggregate demand (and the resulting inflation levels) and bring the economy back to full employment equilibrium by reducing investment via interest rates.
High inflation can lead to serious economic trouble. If high demand causes output to push past full employment levels, the price of goods rises rapidly. Ultimately, if unchecked, the situation can lead to hyperinflation, extreme inflation in which prices spiral out of control as supply cannot keep up with demand. Severe stresses on an economy, such as political turmoil in a country or a sustained period of extreme deficit, can lead to high inflation. Central banks such as the Fed pursue contractionary monetary policy to keep inflation at a desirable level, typically between 2–3% per year. Contractionary monetary policy is sometimes called restrictive monetary policy because the central bank acts to restrict the amount of money in the economy.
Contractionary Monetary Policy Graph
Most of the instruments of contractionary policy are the opposite of the methods of expansionary policy. As a first resort, the Fed will pursue contractionary open-market operations. Treasury notes held by the Fed will be sold to member banks. This reduces the amount of cash held by the banks, which make loans more expensive and thus suppresses demand. As the loans between banks become more expensive in order to satisfy their minimum reserve requirements, the amount of cash available to banks for the purposes of lending is reduced.
The Fed can also raise the rate of interest charged at the discount window. In addition to buying and selling government securities to influence the federal funds rate, the Federal Reserve directly controls the discount rate, the interest rate on short-term loans the Fed offers institutions to help them meet temporary reserve shortages. If the Federal Reserve raises the discount rate, the money supply will fall and market interest rates will rise because banks will reduce their borrowing and potentially call in loans to increase reserves. The increased interest rates and reduction in loans serviced will decrease business investment and decrease aggregate demand.
Contractionary Monetary Policy
Another method used to restrict the money supply is to raise the minimum reserve requirement. The Fed requires all banks to hold a certain minimum amount of funds in reserve, to be used in case of emergency. By increasing the reserve requirement, the Fed can directly diminish the amount of money available to lend and thus control aggregate demand. This is a drastic measure and rarely used because it requires banks to restructure their operations and reconsider their lending policies.
Although contractionary policies make purchases more expensive because they constitute an increase in interest rates, they benefit businesses and individuals who have savings or hold bonds. Contractionary monetary policy has generally been used more frequently than contractionary fiscal policy in recent years because contractionary fiscal policies, such as tax increases, are politically unpopular.