What is a Contractionary Policy?

Contractionary policy is a type of monetary measure which maintains higher than usual short-term interest rates, or which reduces or even shrink the rate of growth in the money supply. This reduces economic growth in the short term and lowers inflation. Contractionary monetary policy can lead to increased unemployment and decreased borrowing and spending by consumers and businesses, which can eventually lead to an economic recession if too aggressively applied. In other words, a contractionary policy is a kind of policy that lays emphasis on reduction in the level of money supply for lesser spending and investment thereafter so as to slow down an economy.

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How is a Contractionary Policy Carried Out?

Contractionary monetary policy is generally undertaken by a central bank or a similar regulatory authority. The central bank usually sets a target for the inflation rate and uses the contractionary monetary policy to meet the target. The policy is a variation of the federal fiscal policy with the goal of slowing down a rapidly expanding economy. Its objective is to curb inflation by restricting the money supply. By tightening the money supply, spending is discouraged. The policy strategizes is to increase interest rates, increase bank reserve requirements, or withdraw money (raising bond rates to allow long-term borrowing). In general, if policymakers are using monetary or fiscal policy to reduce aggregate investment in the sector, contractionary policy is applied. Fast Facts

• Contractionary policy is a kind of policy that focuses on reducing the level of money supply for lower spending and subsequent investment in order to slow the economy down.
• Contractionary policies seek to prevent possible capital market distortions.
• Although the contractionary policy initially aimed at reducing the nominal gross domestic product (GDP), it also resulted in creating smoother business cycles and sustainable economic development.
• Contractionary policies can be applied either as a monetary policy or fiscal policy.
• A contractionary monetary policy is generally undertaken by a central bank or a similar regulatory authority.
• Contractionary monetary policy can lead to increased unemployment and decreased borrowing and spending by consumers and businesses.

Contractionary Policy as Fiscal Policy

The contractionary policy is used as a fiscal policy in the event of fiscal recession, to raise taxes or decrease real government expenditures. The goal of the contractionary fiscal policy is to slow growth to a healthy financial standard. This ranges from 2% to 3% per year. If governments slash or raise taxes, money is taken out of the hands of customers. This also occurs if the government cuts benefits, transfer payments for health programs, public works contracts or the number of government employees. Thus, reducing the supply of money automatically reduces the demand. This gives consumers less buying power and reduces income for companies, causing businesses to cut jobs.

Contractionary Policy as a Monetary Policy

In general, the contractionary policy will be used as a monetary policy to raise interest rates or reduce the supply of capital. It aims at preventing inflation through restrictive monetary policy. The economic reality is that a 2% annual price rise is good because it increases demand. There is an expectation of prices to increase later, so more goods will be purchased now. This is why many central banks have a 2% inflation target. It's harmful if inflation increases dramatically, as people start buying in excess now to avoid paying higher prices in the future. This can force companies to produce more to take advantage of higher demand. It becomes a vicious cycle and produces galloping inflation and even worse, hyperinflation.

Real-World Example

Taking the US inflation rate which rose steadily in the 1970's as an example, statistics from the Federal Reserve Bank of Minneapolis shows that the average percentage change in consumer price index (inflation rate) in the period 1973 to 1983 was: Year Rate of inflation 1973 6.2% 1974 11.1% 1975 9.1% 1976 5.7% 1977 6.5% 1978 7.6% 1979 11.3% 1980 13.5% 1981 10.3% 1982 6.1% 1983 3.2% It can be seen that high inflation rates prevailed in the U.S. in the 1970s and early 1980s. Paul Volcker was able to control the inflation rates when he became chair in 1979 and implemented a contractionary monetary policy. Thus, setting the Federal funds rate to 20%.