Contractionary Monetary Policy

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Definition of Contractionary Monetary Policy:

Contractionary monetary policy is a strategy employed by a central bank, such as the Federal Reserve in the United States, to decrease the money supply and slow economic growth. 

Detailed Explanation:

A central bank usually implements contractionary monetary policy when policymakers are concerned that the economy may overheat and inflation may become excessive. These measures can slow the growth of the money supply.

• Raising its benchmark rate: A central bank raises interest rates across the economy by increasing its benchmark rate. The higher interest rates deter many consumers and businesses from borrowing.
  
  
• Selling Government Bonds: When a central bank sells government bonds it withdraws money from the economy, thus reducing the money supply.
  
  
• Increasing the Reserve Requirement: Raising the reserve requirement means increasing the minimum percentage of deposits that a bank or thrift must hold in its vaults or on deposit with the Federal Reserve Bank. This portion of the money cannot be loaned or invested, ultimately reducing the money supply.
  
  
• Increasing the Discount Rate: The discount rate is the interest rate that the Federal Reserve Banks charge to commercial banks and other depository institutions when they borrow from the Fed at its discount window. If the discount rate is increased, it becomes more expensive for banks to borrow, which discourages lending and slows down the growth of the money supply.
  

Contractionary monetary policy is usually employed when the economy is approaching the peak of a business cycle. In these situations, consumer confidence is high. Most families enjoy higher incomes. Some are purchasing new homes or cars or treating themselves to vacations. Many families and businesses finance their acquisitions with debt, such as mortgages, business loans, car loans, or credit cards. After all, life is good. The economy’s aggregate demand is increasing, and they are confident their incomes will remain high.
During this period, businesses are thriving. Their biggest challenge is accommodating the increase in demand for their goods and services. Workers must work overtime. Companies must pay higher wages to retain workers. They may even need to hire and train new employees. Meanwhile, the rising demand for raw materials pushes up input prices. Manufacturing plants reached their maximum operating capacity. Companies add shifts and delay maintenance to complete customers’ orders. As a result of all this, the economy becomes overheated, and many businesses can’t keep pace with the increase in demand, so they raise their prices to reduce the quantity demanded rather than turn away customers.

The central bank must choose between slowing economic growth to reduce inflation or accepting the inflation and allowing the economy to continue to grow.

The graph below illustrates what is happening and the central bank’s dilemma. Assume the economy begins in its long-run equilibrium where the aggregate demand (AD₁), short-run aggregate supply (SRAS), and long-run aggregate supply (LRAS) are in equilibrium. The economy’s output and price level are Q_A and PL_A, respectively. Congress passed a tax cut that increased the aggregate demand to AD₂, pushing output to Q_B and prices to PL_B. Notice that output increases, but prices increase much more. Somehow, aggregate demand needs to be reduced to closer to AD₁ if inflationary pressures are to be alleviated.

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