Contractionary Monetary Policy: Definition, Examples

Why Do Interest Rates Ever Need to Rise?

contractionary monetary policy
Contractionary monetary policy reduces the money supply. Photo: Peter Dazeley/Getty Images

Definition: Contractionary monetary policy is when the Federal Reserve slows economic growth to prevent inflation. If not exercised with care, it could push the economy into a recession. It is also called restrictive monetary policy.

The Fed's target for inflation is a core inflation rate of 2 percent. Core inflation is year-over-year price increases minus volatile food and oil prices. The Consumer Price Index is the inflation indicator most familiar to the public.

The Fed prefers the Personal Consumption Expenditures Price Index. It uses formulas that smooth out more volatility than the CPI does.

If the PCE Index for core inflation rises much above 2 percent, then the Fed implements contractionary monetary policy.

How Contractionary Monetary Policy Is Implemented

The Fed's first line of defense is raising the target for the fed funds rate. That increases the rate that banks charge each other to borrow funds to meet the reserve requirement. The Federal Reserve requires banks have a certain amount on hand each night when they close their books. For most banks, that's 10 percent of their total deposits. Without this requirement, banks would lend out every single every dollar people deposit. They wouldn't have enough cash in reserve to cover operating expenses if any of the loans defaulted.

Raising the fed funds rate is contractionary because it decreases the money supply.

Banks charge higher interest rates on their loans to compensate for the higher fed funds rate. Businesses borrow less, don't expand as much and hire fewer workers. That decreases demand. Lower demand lowers prices, putting an end to inflation.

Second, the Fed could increase the reserve requirement. This is uncommon.

It's disruptive to banks to change procedures and regulations to meet a new requirement. Raising the fed funds rate is easier and achieves the same aim.

The third tool is open market operations. That's when the Fed buys or sells its holdings of U.S. Treasury notes. To implement contractionary policy, the Fed sells Treasurys to one of its member banks. That reduces the money it has available to lend. That gives the bank an incentive to charge a higher interest rate. Quantitative easing was the opposite of this. For more, see Monetary Policy Tools.

Examples 

There aren't many examples of contractionary monetary policy for two reasons. First, the Fed usually wants the economy to grow, not shrink. More important, inflation hasn't been a problem since the 1970s. 

In 1973, inflation went from 3.9 percent to 9.6 percent. The Fed raised interest rates from 5.75 percent to 13 percent by July 1974. Despite inflation, economic growth was slow, a situation called stagflation. The Fed responded to political pressure and dropped the rate to 7.5 percent in January 1975. The Fed's stop-go monetary policy sent inflation into the 10-12 percent range through April 1975. Businesses didn't lower prices when interest rates went down.

They didn't know when the Fed would raise them again. When Paul Volcker became Fed Chair in 1979, he raised the fed funds rate to 20 percent. He kept it there, finally putting a stake through the heart of inflation.

Former Federal Reserve Chairman Ben Bernanke said contractionary monetary policy caused the Great Depression. The Fed had instituted contractionary monetary policies to curb the hyperinflation of the late 1920s. But during the recession or stock market crash of 1929, it didn’t switch to expansionary monetary policy as it should have. It continued contractionary monetary policy and raised rates.

That was because dollars were still backed by the gold standard. The Fed didn't want speculators to sell their dollars for gold and deplete the Fort Knox reserves. An expansionary monetary policy would have created a little healthy inflation.

Instead, the Fed protected the dollar's value and created massive deflation. That helped turn a recession into a decade-long depression