What is a Contractionary Monetary Policy?

What is a Contractionary Monetary Policy?

Definition

If inflation increases, a country’s central bank can use a contractionary monetary policy to cool the economy and bring down prices. In the U.S., the Federal Reserve can implement a contractionary monetary policy by increasing the “Federal Funds Rate,” which is the rate at which banks lend reserve balances to other banks on an overnight basis.

This results in an increase in other interest rates as well, making credit more expensive. Consequently, there is a contraction in the amount of money that is available in the economy and this leads to lowering the demand for goods and services, which in turn, helps to keep inflation in check.

What does contractionary monetary policy mean?

If there is an excessive amount of money in the economy, it can lead to inflation. How exactly does this happen? Consider a situation where the level of production of goods in a country remains constant while the money supply increases. This will result in “too much money chasing too few goods.” Consequently, prices will rise.

One of the primary functions of a country’s central bank is to keep inflation under control. For example, the Federal Reserve’s target inflation rate is 2% per year. If prices rise at a rate exceeding this, the Fed can use a contractionary monetary policy to bring down the supply of money in the economy.

How does it do this? It can raise the Federal Funds Rate. This has a cascading effect, leading to credit becoming more expensive for businesses and consumers. Interest rates on home loans, car loans, and credit card debts go up. As a result of this, people borrow less and there is a slowdown in demand. This leads to a reduction in the rate of inflation.

However, a contractionary monetary policy could have unintended consequences. It may slow the economy too quickly and this could lead to a recession. Therefore, when a central bank implements a contractionary monetary policy, it monitors the effect on the economy very closely and adjusts interest rates on a periodic basis.

Example of contractionary monetary policy

In the 1970s inflation rates in the U.S. increased steeply. According to data from the Federal Reserve Bank of Minneapolis, the annual percentage change in the consumer price index (rate of inflation) in the period from 1973 to 1983 was:
YearRate of inflation
1973  6.2%
197411.1%
1975  9.1%
1976  5.7%
1977  6.5%
1978  7.6%
197911.3%
198013.5%
198110.3%
1982  6.1%
1983  3.2%
  This table shows that there were high inflation rates in the U.S. in the 1970s and early 1980s. In fact, in 1980 the inflation rate reached a level of 13.5%.

How were runaway inflation rates brought under control? Paul Volcker became Fed Chair in 1979. He imposed a contractionary monetary policy. The Federal Funds Rate was hiked to 20%. This helped to control the inflation rate, which dropped to 3.2% in 1983.

Summary

The central bank of a country can implement a contractionary monetary policy by raising interest rates and decreasing the money supply. This can help to lower inflation but could also lead to a slowdown in economic activity.