An increase in GDP and, frequently, a bullish stock market are classic indicators of economic progress. That’s often a positive thing.
However, there can occasionally be an excess of a good thing. An economy can be growing too quickly, for instance, with excessive demand driving up costs and prices unchecked. Threatening to exceed wages and devalue the national currency is this inflation.
A country’s central bank will execute a contractionary monetary policy to halt the rapid growth and the rise in prices in order to calm down this overheated economic engine.
Contractionary monetary policy: what is it
A central bank, in this case the Federal Reserve in the US, utilizes contractionary monetary policy as a macroeconomic tool to lower inflation.
By lowering the money supply, or the amount of cash and immediately usable funds circulating around the country, the intention is to decrease the pace of the economy. In contrast to expansionary monetary policy, it.
By examining the inflation rate, governments and central banks can determine when an economy is overheated. It makes sense that higher demand would result in some price increases for goods and services. For instance, the US typically views an annual inflation rate of between 2 percent and 3 percent as normal.
However, if inflation is increasing faster than its intended rate of increase, it serves as a warning and serves as the primary impetus for executing a contractionary monetary policy.
Tools for contractionary monetary policy
Three main instruments make up the Federal Reserve’s contractionary monetary policy in the US:
1. rising rates of interest
The Federal Reserve raises two short-term interest rates in particular to limit demand and the amount of money in circulation:
The interest rate that banks charge one another for overnight loans is used to determine the federal funds rate. To ensure that the institution remains solvent, the Federal Reserve mandates that banks keep a percentage of their daily cash deposits on hand rather than lending them out. If certain banks don’t have enough deposits to cover the demand, they borrow from other banks.
The discount rate is set: the interest rate that the Fed assesses on direct bank loans. Because the Federal Reserve is a “lender of last resort,” it is higher than the fed funds rate yet moves in lockstep with it.
2. Offering government bonds
Selling US Treasury bonds and bills, sometimes referred to as open market operations, is another step the Fed is taking to reduce the amount of money in circulation.
Bonds and bills from the US Treasury are deposited to the Fed. Then, the Federal Reserve will sell them to financial institutions, primarily the banks that are Federal Reserve System members.
3. Increasing the reserve minimum
The Fed mandates that banks comply with a “reserve requirement” in addition to keeping a set amount of deposits on hand each night. This requirement requires banks to retain a set amount of cash on hand at all times in case account holders need it. But it may and does change the specifications.
Monetary policy: contractionary versus expansionary
An expansionary monetary policy is the antithesis of contractionary monetary policy.
It is implemented during the opposite part of a business cycle, known as a contractionary phase, when the economy is slowing and GDP is falling.
If this is the case, a central bank will try to expand the money supply by lowering borrowing and spending costs. The same financial tools are also used, but in the opposite direction.
In order to stimulate the economy by raising aggregate demand, the Fed will drop interest rates in the US, lower the reserve requirement, and purchase US Treasury securities.
