Contractionary monetary policy: examples, tools & effects

Contractionary monetary policy (or tight money policy, tight monetary policy) is a type of monetary policy that aims to reduce the money supply. The main objective of contractionary monetary policy is to reduce the rate of economic activity.

Contractionary monetary policy benefits

The benefits of contractionary monetary policy are that it can slow down inflation and deflation in an economy. In a free market, inflation is the general trend of prices going up. This happens naturally because the market economy is constantly changing. There are new demands, new technology, and economies of scale, for example, when there is too much money in the economy, inflation can happen.

If there is too much money in the economy, it may cause more people to use cash rather than put their money in a bank. This increases the amount of cash available, which causes the value of the currency to go down and prices to rise. Contractionary monetary policy means that the government will take action to shrink the money supply.

The purpose of a tight money policy is to reduce demand for goods and services so as to stop or slow down inflation.

A tight monetary policy can also be used in the opposite situation of an excessively overheated economy with very low unemployment, when inflation would result without changes to interest rates. This is known as a ‘preemptive’ contractionary policy. It is often considered that preemptive contractionary policy should only be used during times of extreme economic overheating.

If the Federal Reserve System wants to follow a tight monetary policy to reduce inflation it should raise interest rates, decrease the money supply by selling bonds, and increase taxes to decrease demand for goods and services

Contractionary monetary policy effects

Monetary policy affects aggregate demand through changes in the interest rate. Tight money policy leads to an increase in interest rates and a decrease in spending.

If in place for an extended period, contractionary monetary policy can lead to deflation or depression. When consumers expect continued price declines in the future they avoid consumption, which leads to lower demand and results in economic stagnation.

If consumers hold back on consumption for a long enough period it can become difficult, if not impossible, for businesses to get capital loans because lenders believe their money will be worth less when repaid than when initially deposited due to economic decline. This inhibits business expansion and increases layoffs caused by lack of business activity. Tightening money supply decreases real GDP until inflation is low enough that prices remain stable at equilibrium level where aggregate demand equals aggregate supply of goods and services.

The net export effect of contractionary monetary policy predicts that a country’s currency will decrease in value when they implement tight monetary policies. However the current account is expected to remain unchanged since the currency will decrease in value just enough to offset the increase in the trade balance from implementing a contractionary monetary policy. This theory is supported by the fact that tightening monetary policies are implemented by slowing growth, or decreasing inflation. Both of which are not thought to have a significant effect on increasing a country’s exports.

Why would the fed intentionally use contractionary monetary policy to reduce real gdp?

This is usually done to slow inflation. If the economy is growing too quickly, the Federal Reserve (the Fed) will contract the money supply in order to reduce the real GDP (GDP adjusted for inflation). This typically occurs when the economy is experiencing high growth during a recovery from recession.

The Fed is trying to achieve a contraction in the growth of the money supply. In order to do this, it sells government securities on the open market. That decreases the amount of money in circulation and leads to a decrease in GDP (which can lead to recession). Then, if it needs to stimulate the economy, it will buy back the securities on the open market. That increases the money supply, leading to an increase in GDP.

Contractionary monetary policy examples

The most notable examples of contractionary monetary policy were the Volcker Recession in the U.S. and several European recessions after 2011, during which central banks raised interest rates. During these periods of tight money, economic growth was limited or stagnant for several quarters while inflation declined to acceptable levels (1-5 percent), where it would remain until the formation of another boom period when tightening monetary policy would be employed again.

Contractionary monetary policy tools

  1. Reserve requirements
  2. Raising the interest rate
  3. Discounting
  4. Proportional discounting
  5. Constant dollar
  6. Regulation Q
  7. Taxation

Due to the fact that there are multiple types of policy tools available, contractionary monetary policy can be carried out using one or more of the following tools.

Reserve requirements

Reserve requirements refers to the minimum amount of funds a bank must hold in reserves. A reserve requirement is a ratio that determines how much money commercial banks must hold in reserve; the higher the ratio, the more money banks must keep on hand instead of lending out.

Raising the interest rate

By raising the interest rate (either at a particular bank or throughout the banking system), the bank will be able to make more money from loans and investments. The reason for this is that when interest rates are high, people tend to not to spend as much because they know that it takes a lot of money to purchase something and usually wait until later when it may be cheaper. This means fewer bags and shoes will be bought which lowers demand and in turn decreases prices.

Discounting

The Federal Reserve uses the discount rate to encourage banks not to over produce money; that is, they want them to lend out less money than they can actually back with hard currency (aka gold). If a bank were to borrow from the Federal Reserve, they would have to pay a premium, which acts as a disincentive to borrow.

Proportional discounting

Under this type of policy, the amount of money a bank is allowed to create remains unchanged when the Fed changes its interest rate target. In other words, if the reserve requirement were 10 percent and the central bank wanted it to be 15 percent, every bank would have to raise its reserve ratio by 5 percent.

Constant dollar

Under this type of policy, the amount of money a bank is allowed to create remains unchanged when the Fed changes its interest rate target. In other words, if the reserve requirement were 10 percent and the central bank wanted it to be 15 percent, every bank would have to raise its reserve ratio by 5 percent.

Regulation Q

Regulation Q is the portion of the Federal Reserve Act that prohibits payment of interest on checking accounts, negotiable order of withdrawal (NOW) accounts, and share draft accounts (the “Reg Q” or “Reg-Q” types of assets). These regulations were enacted some time after the Great Depression as a result of the Fed’s belief that paying interest on these types of accounts would promote reckless, speculative behavior.

Taxation

This is an indirect way for monetary policy to create contractionary effects upon the economy. The sale of T-Bills creates new income for the government, increasing revenue. A portion of this income is spent while some is saved. The portion that is spent will be diverted from the consumers who spent it, thus reducing aggregate demand.

FAQs on tight monetary policy

When is contractionary monetary policy used?

Contractionary monetary policy is used when there is a possibility of an inflationary problem in an economy. The central bank pushes interest rates higher to discourage borrowing, which would slow down the economy.

How does tight and loose monetary policy affect interest rates?

When a central bank implements tightening monetary policy the interest rate will increase. When the Federal Reserve enacts tight monetary policy they decrease money supply by selling government bonds. This reduces the amount of money in circulation and lowers the demand for credit, which leads to an increase in interest rates.

The Federal Reserve increases interest rates by buying government bonds with newly printed money. This increases the supply of credit and money in circulation and leads to a decrease in the interest rate.

How does contractionary monetary policy reduce inflation?

Contractionary monetary policy is a way of reducing inflation. The reasoning behind this is that when money supply decreases, the value will rise.
There is a direct relationship between inflation and money supply. When the government print more money, more money will come into circulation. This will lead to inflation.

What is the difference between loose and tight money policies?

A tight monetary policy is where the central bank of a country reduces the availability of money within the economy. This tight money policy is used to slow or stop inflation and usually involves a rise in short-term interest rates.

Loose monetary policy is where the central bank of a country increases the availability of money within an economy thus lowering interest rates and making more funds available for borrowing.

Contractionary monetary policy reduces inflation by slowing consumer spending, whereas a loose monetary policy increases inflation by encouraging consumer spending.

Tight money policies are often implemented to reduce inflation and an expansionary monetary policy is likely to be adopted to reduce the problems of low employment and deflation.

Leave a Comment