Contractionary monetary policy is when a central bank uses its monetary policy tools to fight inflation. It's how the bank slows economic growth. Inflation is a sign of an overheated economy. It's also called a restrictive monetary policy because it restricts liquidity.
The bank will raise interest rates to make lending more expensive. That reduces the amount of money and credit that banks can lend. It lowers the money supply by making loans, credit cards, and mortgages more expensive.
Purpose of Monetary Policy
The purpose of a restrictive monetary policy is to ward off inflation. A little inflation is healthy. A 2% annual price increase is actually good for the economy because it stimulates demand. People expect prices to be higher later, so they may buy more now. That's why many central banks have an inflation target of around 2%.
If inflation gets much higher, it's damaging. People buy too much now to avoid paying higher prices later. This consumer buying may cause businesses to produce more to take advantage of higher demand. If they can't produce more, they'll raise prices further. They may take on more workers. Now people have higher incomes, so they spend more. It becomes a vicious cycle if it goes too far. It creates galloping inflation where inflation is in the double-digits. Even worse, it can result in hyperinflation, where prices rise 50% a month.
To avoid this, central banks slow demand by making purchases more expensive. They raise bank lending rates. That makes loans and home mortgages more expensive. It cools inflation and returns the economy to a healthy growth rate of between 2% and 3%.
The U.S. central bank is the Federal Reserve. It measures inflation using the core inflation rate. Core inflation is year-over-year price increases minus volatile food and oil prices. The Consumer Price Index (CPI) 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%, then the Fed implements contractionary monetary policy.
How Central Banks Implement Contractionary Policy
Central banks have lots of monetary policy tools. The first is open market operations. Here's how the Federal Reserve tools are used in the U.S.
The Fed is the official bank for the federal government. The government deposits U.S. Treasury notes at the Fed like you deposit cash. To implement a contractionary policy, the Fed sells these Treasurys to its member banks. The bank must pay the Fed for the Treasurys, reducing the credit on its books. As a result, banks have less money available to lend. With less money to lend, they charge a higher interest rate.
The opposite of restrictive open market operations is called quantitative easing. That's when the Fed buys Treasurys, mortgage-backed securities, or bonds from its member banks. It is an expansionary policy because the Fed simply creates the credit out of thin air to purchase these loans. When it does this, the Fed is “printing money.”
The Fed can also raise interest rates by using its second tool, the fed funds rate. It's the rate that banks charge each other to borrow funds to meet the reserve requirement. The Fed requires banks to have a specific reserve on hand each night. For most banks, that's 10% of their total deposits. Without this requirement, banks would lend out every single dollar people deposited. They wouldn't have enough cash in reserve to cover operating expenses if any of the loans defaulted.
The Fed raises the fed funds rate to 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 reduces demand. As people shop less, firms slash prices. Falling prices put an end to inflation.
The Fed's third tool is the discount rate. That's what it charges banks who borrow funds from the Fed's discount window. Banks rarely use the discount window, even though the rates are usually lower than the fed funds rate. That's because other banks assume the borrowing bank must be weak since it is forced to use the discount window. In other words, banks hesitate to lend to those banks who borrow from the discount window. The Fed raises the discount rate when it raises the target for the fed funds rate.
The Fed rarely uses its fourth tool, increasing the reserve requirement. It's disruptive for banks to change procedures and regulations to meet a new requirement. Raising the fed funds rate is easier and achieves the same aim.
Effects and Examples
Higher interest rates make loans more expensive. As a result, people are less likely to buy houses, autos, and furniture. Businesses can't afford to expand. The economy slows. If not exercised with care, the contractionary policy can push the economy into a recession.
There aren't many examples of contractionary monetary policy for two reasons. First, the Fed wants the economy to grow, not shrink. More importantly, inflation hasn't been a problem since the 1970s.
In the 1970s, inflation grew to exceed 10%. In 1974, it went from 4.9% in January to 11.1% in December. The Fed raised interest rates to almost 13% by July 1974. Despite inflation, economic growth was slow. That situation is called stagflation. The Fed responded to political pressure and dropped the rate to 7.5% in January 1975.
Businesses didn't lower prices when interest rates went down. They didn't know when the Fed would raise them again. After Paul Volcker became Fed Chair in 1979, the fed funds rate increased to a peak of 20% in 1981. He kept it there, finally putting a stake through the heart of inflation.
Former Fed Chair Ben Bernanke said contractionary policy caused the Great Depression. The Fed had instituted contractionary monetary policies to curb the hyperinflation of the late 1920s. During the recession or stock market crash of 1929, it didn’t switch to expansionary monetary policy as it should have. It continued contractionary policy and raised rates.
It did so because the gold standard backed the dollars. 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.
How Contractionary Differs From Expansionary Policy
Expansionary monetary policy stimulates the economy. The central bank uses its tools to add to the money supply. It often does this by lowering interest rates. It can also use expansionary open market operations, called quantitative easing.
The result is an increase in aggregate demand. It boosts growth as measured by gross domestic product. It lowers the value of the currency, thereby decreasing the exchange rate.
Expansionary monetary policy deters the contractionary phase of the business cycle. But it is difficult for policymakers to catch this in time. As a result, you'll often see the expansionary policy used after a recession has started.