Contractionary Monetary Policy
View FREE Lessons!
Definition of Contractionary Monetary Policy:
Contractionary monetary policy
is a monetary policy designed to restrict the growth of the money supply and slow economic growth. Usually its objective is to reduce inflation. It is also referred to as restrictive or tight monetary policy.
Sometimes an economy can grow too fast. Assume the economy is nearing the peak of a business cycle, and we have the following scenarios.
Consumer confidence is high. Most families enjoy higher incomes. Some purchase a new home. Others may purchase a new car, or treat themselves to a nice vacation. Many families and businesses finance their acquisitions with debt, such as a mortgage, business loan, car loan, or credit cards. After all, life is good. The economy’s aggregate demand is increasing, and they are confident that their incomes will remain high.
Businesses are thriving. Their biggest challenge is accommodating the increase in demand for their goods and services. Workers may be pushed to work overtime. Companies must pay higher wages to retain workers. They may even need to hire and train new employees. Meanwhile, the rising demand for raw materials pushes up input prices. Manufacturing plants are being stretched to their maximum operating capacity. Extra shifts are added. Scheduled maintenance is delayed to complete customers’ orders. As a result of all of this, the economy becomes overheated, and many businesses just can’t keep pace with the increase in demand. Growth at this pace is unsustainable for extended periods, so prices must go up to slow the growth in the quantity of goods and services demanded. Therefore businesses raise their prices rather than turn customers away.The central bank must choose between slowing economic growth to reduce inflation or accept the inflation and allow the economy to continue to grow.
The graph below illustrates what is happening and the central bank’s dilemma. Assume the economy begins in its long-run equilibrium where the aggregate demand (AD), short-run aggregate supply (SRAS), and long-run aggregate supply (LRAS) are in equilibrium. The economy’s output and price level are QA
, respectively. Assume a tax cut increases the aggregate demand to AD2
, pushing output to QB
and prices to PLB
. Notice that output increases, but prices increase much more. Somehow the aggregate demand must be reduced to closer to AD1
if inflationary pressures are to be alleviated.
Monetary Policy - The Power of an Interest Rate
Causes of Inflation
Fiscal Policy - Managing an Economy by Taxing and Spending
Aggregate Supply and Demand - Macroeconomic Equilibrium
Causes of Inflation
What can reverse the continuing increase in prices? Higher interest rates will help slow the sales of interest-sensitive items such as cars, homes, and financed equipment. Central banks use a contractionary monetary policy to increase interest rates by slowing the growth in the money supply. In the United States, the Fed may tighten credit by increasing the discount rate (the rate the Federal Reserve Banks charge banks that go to the Fed’s window to beef up their required reserves), increasing the banking system’s reserve requirement (which decreases the money available for lending), and increasing the federal funds rate through Federal Open Market Operations. Each strategy decreases the reserves available for banks to lend. The cost of a contractionary monetary policy is slower economic growth, but the benefit is less inflation.
Dig Deeper With These Free Lessons: