Tight Monetary Policy - Explained
What is Tight Monetary Policy?
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Table of ContentsWhat is Tight Monetary Policy?How does Tight Monetary Policy Work?Academic Research on Tight Monetary Policy
What is Tight Monetary Policy?
Tight monetary policy, also known as contractionary policy, refers to a policy that a countrys central bank like the Federal Reserve regulates for controlling the excessive economic growth. These policies focus on decreasing the spending capacity, or controlling inflation that is accelerating at an abnormal rate. The central bank follows the money tightening approach by increasing short-term rates of interest to the discounted rates, which is also called the federal funds rate. When interest rates are increased, people tend to borrow less. Besides increasing interest rates, the central bank can also engage in open market operations, and sell assets in the market. Tight monetary policy and a tight fiscal policy, in spite of being different from one another, can be brought in sync by government authorities. This involves increasing tax rates or reducing government expenditure.
How does Tight Monetary Policy Work?
Central banks throughout the world use monetary policy for regulating and managing various variables functioning within the economy. These banks consider using the federal funds rate in order to adjust market factors. When central banks increase the federal funds rate, it results in tightening of the monetary policy. In case, the federal funds rates are reduced, it will result in loosening of the policy. International economies use the federal funds rate as premises for the monetary policy. The rate at which federal banks can offer loans to each other is referred to as the federal funds rate. It is also called the discount rate. When federal rates are increased, it results in increasing the interest rates of borrowing too. Ultimately, the higher interest payments reduce the borrowing capacity of people. Besides personal loans, other types of borrowings such as interest rates on credit cards, mortgages, etc. also become expensive. Also, when rates of borrowing are hiked during the tight monetary policy, people tend to save more with rising interest rates on savings. When the focus is on tightening the monetary policy, it calls for selling assets in the open market for having some additional amount of capital. This leads to extracting capital from the open markets as the Fed uses the funds derived from sale with a promise of reimbursing the principal amount as well as the interest thereon. Also, a decrease in the supply of money can also control inflation. The Fed uses the tight monetary policy approach when the economy is growing at a rapid pace. In contrast to tight monetary policy, easing monetary policy takes place when the central bank reduces interest rates for infusing more growth in the economy. With the reduction in interest rates, consumers tend to take more loans, which ultimately increases the money supply in the economy. There are several countries that have reduced their federal funds rates to nil. Also, there are some that have these rates in negatives. These zero and negative numbers help the economy in securing easy borrowings. When the rates are extremely negative, borrowers also get interest rates which can lead to the creation of more credit demand in the economy.
Academic Research on Tight Monetary Policy