Restrictive monetary policy is how central banks slow economic growth. It's called restrictive because the banks restrict liquidity. It 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. That constricts demand, which slows economic growth and inflation. Restrictive monetary policy is also known as contractionary monetary policy.
The purpose of 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 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 causes businesses to produce more to take advantage of higher demand. If they can't produce more, they'll raise prices further. They take on more workers, so people have higher incomes, so they spend more. It becomes a vicious cycle if it goes too far. That's because it can create galloping inflation, where inflation is in the double-digits. Even worse, it can result in hyperinflation, where prices rise 50% a month. Economic growth wouldn’t be able to keep up with prices. For more, see Types of Inflation.
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 2% to 3% percent.
How Central Banks Implement Restrictive Policy
Central banks have a lot of monetary policy tools. The first is open market operations. Here's an example of how it works in the United States.
The Federal Reserve is the central bank for the federal government, including the U.S. Treasury. When the government has more cash than it needs, it will deposit Treasury notes at the central bank. When the Fed wants to reduce the money supply, it sells these Treasurys to its member banks. The banks pay for the securities with some of the cash they have on hand to meet their reserve requirement. Holding Treasurys means they now have less cash to lend. It reduces liquidity.
The opposite of restrictive open market operations is called quantitative easing. That's when the Fed buys Treasurys, mortgage-backed securities or any other type of bond or loan. 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 Federal Reserve uses open market operations to raise the fed funds rate if it wants a restrictive monetary policy. It is the rate banks charge each other for overnight deposits.
The Fed mandates that banks must keep a certain amount of cash, or reserve requirement, on deposit at their local Federal Reserve branch office at all times. At the close of business, a bank might have a bit more than it needs to meet the reserve requirement. If so, it will lend it, charging the fed funds rate, to another bank that doesn't have quite enough.
A higher fed funds rate makes it more expensive for banks to keep their mandated reserve. It restricts the monetary supply enough to slow the economy.
The Fed could also raise 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 bank must be weak if it's 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 least likely thing the Fed would do is raise the reserve requirement. It would immediately reduce the money banks could lend. It would also require the banks to develop new policies and procedures. It would have no advantage over raising the fed funds rate, which is just as effective.