What is Contractionary Monetary Policy?

Contractionary monetary policy is a strategic approach employed by central banks to effectively lower inflation and economic activity within a country. This is primarily achieved through the implementation of various tools, such as interest rate hikes, raising reserve requirements for commercial banks, and engaging in large-scale government bond sales, commonly referred to as quantitative tightening (QT).

The objective of contractionary monetary policy is to address situations where an economy is operating beyond a sustainable level. When an economy is in this state, it can result in unwanted effects like inflation, which refers to a general rise in the price of goods and services purchased by households.

confused man looking at monetary policy terminology

Contractionary Monetary Policy Tools

1) Raising the Benchmark Interest Rate

The benchmark interest rate, also known as the base interest rate, denotes the interest charged by a central bank to commercial banks for overnight loans. This specific rate serves as a foundation from which other interest rates are derived. For instance, when individuals or businesses take out mortgages or personal loans, the interest rates for these loans are typically based on the benchmark rate, with additional percentages added by commercial banks to cover interest income and credit risk premiums.

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By raising the base interest rate, all other interest rates linked to it are elevated, resulting in increased interest-related costs across the board. This, in turn, leads to decreased disposable income for individuals and businesses, ultimately resulting in reduced spending and circulation of money within the economy.

2) Raising Reserve Requirements

Commercial banks are required to maintain a fraction of their client deposits with the central bank. This practice, known as reserve requirements, serves multiple purposes, including providing liquidity to banks in times of potential withdrawals and enabling the central bank to control the supply of money within the economy.

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During periods of economic overheating, central banks can opt to raise reserve requirements, thereby constraining the amount of money that can be lent out by commercial banks to the public. This reduction in lending, combined with higher interest rates, successfully lowers economic activity, aligning with the intended objectives of contractionary monetary policy.

3) Open Market Operations (Mass Bond Sales)

Central banks also utilize open market operations, specifically mass bond sales, as a means to tighten financial conditions and regulate the economy. These operations involve the sale of government securities, often referred to as government bonds.

When bonds are sold, buyers or investors must utilize their funds to make the purchase. As a result, the central bank effectively removes these funds from the system for the duration of the bond’s lifespan. Selling substantial quantities of bonds leads to a decrease in their price, thereby raising the bond yield. This, in turn, makes it more expensive for the government to borrow money, forcing a reduction in unnecessary spending.

The Effect of Contractionary Monetary Policy

1) Effect of Higher Interest Rates

One of the primary consequences of implementing contractionary monetary policy is the increase in interest rates within the economy. Higher interest rates translate to greater costs associated with borrowing money, resulting in a reduction in large-scale capital investments and general spending. Individually, this means that mortgage payments rise, leaving households with a decrease in disposable income.

road sign showing Fed rate hike ahead

Another significant impact of higher interest rates is the concept of opportunity cost. In a rising interest rate environment, interest-linked investments and bank deposits become more appealing, as they offer greater returns. However, it’s important to consider inflation in this context, as high inflation can still result in negative real returns for savers if it surpasses the nominal interest rate.

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2) Effect of Raising Reserve Requirements

As previously mentioned, raising reserve requirements allows central banks to control the supply of money circulating within the economy. By increasing these requirements, commercial banks are forced to withhold a larger portion of their capital, thereby limiting the amount available for loans. The combination of higher interest rates and reduced lending activity leads to a decline in economic activity, aligning with the goals of contractionary monetary policy.

3) Effect of Open Market Operations (Mass Bond Sales)

Central banks utilize open market operations, specifically mass bond sales, as a strategic tool to regulate government borrowing costs and overall spending. When significant amounts of government securities are sold, the price of the bonds decreases, subsequently increasing their yield. This implies that the government must pay higher interest rates to borrow money, effectively curbing unnecessary expenditure.

Examples of Contractionary Monetary Policy

Contractionary monetary policy is often a complex endeavor, as numerous external variables can influence its outcomes. Central bankers, therefore, build flexibility into their approaches, allowing them to navigate unintentional consequences. Additionally, they often adopt a data-dependent approach, responding to specific situations accordingly.

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To illustrate the application of contractionary monetary policy, let’s consider two instances in the US that involved its implementation.

During the period from May 2004 to June 2006, contractionary monetary policy was employed with the intention of reducing inflation and tempering economic activity. However, it’s essential to note that inflation tends to lag behind rate hikes as the effects take time to filter through the economy. Therefore, despite the rising rates, inflation continued to increase before eventually decreasing.

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Similarly, from December 2015 to December 2018, the objective was to lower inflation and economic activity through contractionary measures. However, external shocks, such as the global financial crisis (GFC) in 2008/2009 and the outbreak of the coronavirus pandemic in 2020, disrupted the normal course of contractionary monetary policy. These crises underscore the challenges faced by central banks in successfully implementing and sustaining contractionary measures.

economic data when analyzing contractionary monetary policy

In conclusion, contractionary monetary policy serves as a vital tool for central banks in managing inflation and economic activity. By utilizing various measures such as raising interest rates, increasing reserve requirements, and engaging in mass bond sales, central banks can effectively control the economic environment. However, the effectiveness of these policies relies on a multitude of factors, including external shocks and the ability to navigate unintended consequences, underscoring the complexity of implementing contractionary monetary policy.