Contractionary monetary policy
Encyclopedia
Contractionary monetary policy is monetary policy
that seeks to reduce the size of the money supply
. In most nations, monetary policy is controlled by either a central bank
or a finance ministry.
New classical
and Keynesian
economics significantly differ on the effects and effectiveness of monetary policy on influencing the real economy; there is no clear consensus on how monetary policy affects real economic variables (aggregate output or income, employment). Both economic schools accept that monetary policy affects monetary variables (price levels, interest rates).
Monetary policy relies on a number of tools: monetary base
, reserve requirement
s, discount window
lending and interest rate
s.
A central bank can use open market operations to reduce the monetary base. The central bank would typically sell bonds
in exchange for hard currency
. When the central bank collects this hard currency payment, it removes that amount of currency from the economy, thus contracting the monetary base.
. This acts as a reduction in the money supply.
Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can set the federal funds rate
by open market operations. This rate has significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations are a relatively small part of the total volume in the bond market.
In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply
, because higher interest rates encourage savings and discourage lending. Both of these effects reduce the size of the money supply.
. Inflation is defined as continuing increases in price levels. Since price level is a monetary variable, monetary policy can affect it. Contractionary monetary policy has the effect of reducing inflation by reducing upward pressure on price levels.
Note that inflation can also be affected by fiscal policy
. However, contractionary fiscal policy is often politically unpopular, because it involves spending cuts and tax increases. Thus, politicians favor the use of monetary policy to control inflation.
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...
that seeks to reduce the size of the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
. In most nations, monetary policy is controlled by either a central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
or a finance ministry.
New classical
New classical macroeconomics
New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics...
and Keynesian
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...
economics significantly differ on the effects and effectiveness of monetary policy on influencing the real economy; there is no clear consensus on how monetary policy affects real economic variables (aggregate output or income, employment). Both economic schools accept that monetary policy affects monetary variables (price levels, interest rates).
Monetary policy relies on a number of tools: monetary base
Monetary base
In economics, the monetary base is a term relating to the money supply , the amount of money in the economy...
, reserve requirement
Reserve requirement
The reserve requirement is a central bank regulation that sets the minimum reserves each commercial bank must hold of customer deposits and notes...
s, discount window
Discount window
The discount window is an instrument of monetary policy that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions...
lending and interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
s.
Monetary base
Contractionary policy can be implemented by reducing the size of the monetary base. This directly reduces the total amount of money circulating in the economy.A central bank can use open market operations to reduce the monetary base. The central bank would typically sell bonds
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
in exchange for hard currency
Hard currency
Hard currency , in economics, refers to a globally traded currency that is expected to serve as a reliable and stable store of value...
. When the central bank collects this hard currency payment, it removes that amount of currency from the economy, thus contracting the monetary base.
Reserve requirements
The monetary authority exerts regulatory control over banks. Contractionary policy can be implemented by requiring banks to hold a higher proportion of their total assets in reserve. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By requiring a higher proportion of total assets to be held as liquid cash, a central bank or finance ministry reduces the availability of loanable fundsLoanable funds
In economics, the loanable funds market is a hypothetical market that brings savers and borrowers together, also bringing together the money available in commercial banks and lending institutions available for firms and households to finance expenditures, either investments or consumption...
. This acts as a reduction in the money supply.
Discount window lending
Many central banks or finance ministries have the authority to lend funds to financial institutions within their country. By calling in existing loans the central bank can directly reduce the size of the money supply. By advertising that the discount window will be reduced for future lending, the central bank can also indirectly reduce the money supply by reducing risk-taking by financial institutions.Interest rates
The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates.Monetary authorities in different nations have differing levels of control of economy-wide interest rates. In the United States, the Federal Reserve can set the federal funds rate
Federal funds rate
In the United States, the federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend...
by open market operations. This rate has significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations are a relatively small part of the total volume in the bond market.
In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
, because higher interest rates encourage savings and discourage lending. Both of these effects reduce the size of the money supply.
Monetary policy and inflation
Monetary policy can be used to control inflationInflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
. Inflation is defined as continuing increases in price levels. Since price level is a monetary variable, monetary policy can affect it. Contractionary monetary policy has the effect of reducing inflation by reducing upward pressure on price levels.
Note that inflation can also be affected by fiscal policy
Fiscal policy
In economics and political science, fiscal policy is the use of government expenditure and revenue collection to influence the economy....
. However, contractionary fiscal policy is often politically unpopular, because it involves spending cuts and tax increases. Thus, politicians favor the use of monetary policy to control inflation.