A central bank’s rate of monetary expansion must be reduced, or government expenditure, especially deficit spending, must be reduced as part of a contractionary strategy. It is a specific kind of macroeconomic instrument meant to counteract increasing inflation or other economic distortions brought on by central banks or government actions. The complete opposite of expansionary policy is contractionary policy.
What is Contractionary Monetary Policy?
The goal of contractionary policies is to prevent possible capital market distortions. High inflation brought on by a rising money supply, inflated asset values or crowding out effects where a rise in interest rates results in a decline in private investment expenditure – are examples of distortions. These consequences diminish the initial rise in overall investment spending.
Although the contractionary strategy has the initial impact of lowering nominal Gross Domestic Product (GDP), which is defined as the GDP evaluated at current market prices, it usually leads to long-term economic growth and more stable business cycles.
When Paul Volcker, the then-chairman of the Federal Reserve, finally brought a stop to the skyrocketing inflation of the 1970s, the contractionary policy was notable for taking place in the early 1980s. Target federal fund interest rates were close to 20% at their highest point in 1981.
The measured inflation rate dropped from around 14% in 1980 to 3.2% in 1983.
How Does Contractionary Monetary Policy Work?
A central bank or other such regulatory body often implements contractionary monetary policy. In most cases, the central bank sets an inflation objective and uses the contractionary monetary policy to achieve it.
The program’s objective, which is a variant of the federal fiscal policy, is to slow down a quickly developing economy. Its goal is to reduce inflation by limiting the availability of money. Spending is deterred by reducing the money supply. The strategy for the policy is to raise interest rates, raise the number of bank reserves required, or remove money (raising bond rates to allow long-term borrowing).
Contractionary policy is typically used when decision-makers employ monetary or fiscal policy to lower total investment in the industry.
Contractionary Policy as Fiscal Policy
Governments implement fiscal policies that are more restrictive by increasing taxes or reducing spending. In its most basic forms, these policies drain resources from the private sector to rein in excessive output or bring down asset values.
A rise in taxes is rarely viewed as a viable contractionary policy in modern society. Instead, most contractionary fiscal policies reverse prior fiscal expansions by cutting back on spending – and even then, only in specific areas.
A contractionary policy may have a stimulating impact by increasing the private or non-governmental sector of the economy if it lowers the amount of crowding out in the private markets. This was true throughout the Forgotten Depression of 1920 to 1921 and the immediate post-World War II period, when significant reductions followed rapid economic expansion in government spending and increased interest rates.
Contractionary Policy as Monetary Policy
Modern central banks’ influence over higher base interest rates or other mechanisms that expand the money supply is what drives contractionary monetary policy. By reducing the quantity of active money circulating in the economy, inflation is to be decreased.
It also tries to stop capital investment and speculation that earlier expansionary policies may have sparked. In the US, a contractionary policy is often executed by raising the target federal funds rate; the interest rate banks charge each other for overnight loans.
The Fed may also increase reserve requirements for member banks to reduce the money supply. It may also carry out open-market operations by selling assets, such as US Treasury bonds, to significant investors. These many sales reduce the market value of these assets and raise their yields, making them more affordable for bondholders and savers.
Takeaways
- The complete opposite of expansionary policy is contractionary policy.
- The goal of contractionary policies is to prevent possible capital market distortions.
- A central bank or other such regulatory body often implements contractionary monetary policy.
- Governments implement fiscal policies that are more restrictive by increasing taxes or reducing spending.
