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. The Fed must do this without pushing the economy into a recession. The Fed's target for inflation is 2% for the core inflation rate. That's year-over-year price increases except volatile food and oil prices. The Consumer Price Index  is the most popular inflation indicator. The Fed prefers the Personal Consumption Expenditures Price Index.

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% of their total deposits. Without this requirement, banks would lend out single every dollar they get in. They wouldn't have enough cash 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, decreasing demand. They are also less likely to raise prices, putting an end to inflation.

Second, the Fed could increase the reserve requirement.

The Fed does this rarely. 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 the Fed uses in contractionary monetary policy 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 Treasuries to one of its member banks. The bank pays for the securities by adding to its reserves. That reduces the money it has available to lend so that it will charge a higher interest rate. The Fed did the opposite of this when it launched Quantitative Easing. 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% to 9.6%. The Fed raised interest rates, from 5.75% to 13% 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% in January 1975. The Fed's stop-go monetary policy sent inflation into the 10-12% 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%. He kept it there, finally putting the stake through the heart of inflation.

Former Federal Reserve Chairman Ben Bernanke said contractionary monetary policy caused the Great Depression.

The Fed instituted contractionary monetary policies to curb the hyperinflation of the late 1920s. But it didn't lower rates during the recession or stock market crash of 1929. Instead, it raised them.

At that time, 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. 

Also Known as: Restrictive monetary policy