When to Use Contractionary Monetary Policy

Posted by on Apr 18, 2022 in Uncategorized | 0 comments

Also, less money to lend means banks charge a higher interest rate when they do, making borrowing (and the things they borrow for) more expensive. Restrictive monetary policy occurs when a central bank uses its monetary policy instruments to fight inflation. In this way, the bank slows down economic growth. Inflation is a sign of an overheated economy. It is also known as restrictive monetary policy because it restricts liquidity. The slowdown in the economy is the objective of a monetary policy of contraction. It is also cited as one of the shortcomings of this monetary policy. For example, if loans are more expensive, a company may delay the expense of upgrading its computer system and settle for the old one. The entrepreneur who would have modernized it loses the money he would have earned. Workers also lose the problem: when the economy slows, wages remain unchanged and unemployment rises. Each monetary policy uses the same instruments. The main instruments of monetary policy are short-term interest ratesInterest rateAn interest rate refers to the amount a lender charges a borrower for each form of debt, usually expressed as a percentage of principal, reserve requirements and open market operations.

A monetary policy of contraction uses the following variants of these instruments: governments pursue a fiscal policy of contraction by raising taxes or reducing public spending. In its crudest form, this policy sucks money from the private sector in the hope of slowing down unsustainable output or driving down asset prices. Nowadays, increasing the level of taxation is rarely seen as a viable contraction measure. Instead, most restrictive fiscal measures end the previous fiscal expansion by cutting public spending – and even then only in target sectors. Thus, the Fed`s monetary policy instruments can be effective in bringing the economy back to the maximum employment component of the dual mandate when the economy is weak. The purpose of contractionary monetary policy is to prevent these brutal shocks. To slow economic growth, the central bank must curb demand by making it more expensive to buy goods and services, at least for a while. A well-known economic model called the Phillips curve (discussed in the chapter The Keynesian Perspective) describes the short-run trade-off generally observed between inflation and unemployment. Based on the discussion of expansionary and contractionary monetary policy, explain why one of these variables generally decreases as the other increases. He did it because the gold standard supported dollars. The Fed did not want speculators to sell their dollars for gold and deplete Fort Knox`s reserves.

An expansionary monetary policy would have led to somewhat healthy inflation. Instead, the Fed protected the value of the dollar and created massive deflation. This has helped turn a recession into a depression that has lasted for decades. These measures would result in alternative market interest rates and broader financial conditions. It is a kind of macroeconomic tool to combat rising inflation or other economic distortions caused by central banks or government intervention. The policy of contraction is the exact opposite of expansive politics. Runaway inflation is not a common problem. This, combined with the fact that governments want an economy to grow, means that contractionary monetary policy has not been applied as often. The opposite of open market restrictive operations is called quantitative easing. Then the Fed buys government bonds, mortgage-backed securities, or bonds of its member banks. This is an expansionary policy because the Fed simply creates credit out of thin air to buy these loans.

When this is the case, the Fed “prints money.” Interest rates are a central bank`s most important monetary policy instrument. Expansionary monetary policy will lower interest rates and stimulate investment and consumer spending, resulting in the shift of the initial aggregate demand curve (AD0) to the right towards AD1, so that the new equilibrium (E1) occurs at the potential GDP level of 700. Suppose the economy weakens and employment falls short of the Fed`s maximum employment target. Meanwhile, the inflation rate is showing signs that it will fall below target. The Federal Open Market Committee (FOMC) may decide to use expansionary monetary policy to stimulate the economy. That is, the FOMC could lower its target range for the federal funds rate (FFR). The Fed would lower its administered interest rates – reserve asset interest rates (IORB), overnight repurchase agreement (ON RRP) and discount – accordingly. See the animation below. Definition: A contractionary monetary policy is a macroeconomic strategy used by a central bank to reduce the money supply in the market in order to control inflation. The Federal Reserve and the government control the money supply by adjusting interest rates, buying government bonds on the open market, and adjusting government spending.

To cool this overheated economic engine, a country`s central bank will implement a contractionary monetary policy to slow rapid growth and price increases. The problem arises when there is too much demand in the present. If companies can no longer produce or if their production costs increase too much, they increase prices. Things start to cost more than their intrinsic value, and when prices get too high, it ends up stifling demand – because people can no longer afford to buy. Inflation levels are the main objective of a contractionary monetary policy. By reducing the money supply in the economy, policymakers are trying to reduce inflation and stabilize prices in the economy. Expansionary monetary policy deters the contraction phase of the business cycle. But it is difficult for policymakers to understand this in time. As a result, you will often see the expansive policies used after the onset of a recession. In the United States, the Federal Reserve`s monetary policy of contraction consists of three main instruments: the Fed maintains a portfolio of government bonds and treasury bills that are sold to commercial banks in exchange for securities. This strategy forces banks to charge higher interest rates, which leads to a reduction in the money supply.